John Mauldin's Outside the Box : The Dollar

2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell

John Mauldin — Mon, 18 Jan 2010 18:28:55 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 track record in this decade has been quite good. I want to thank Gary and his associate Fred Rossi for allowing us to view this smaller version of his latest letter.

If you are interested in his letter, 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 the full 2010 forecast with price targets, but an extra issue with his 2011 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

2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell

(excerpted from the January 2010 edition of A. Gary Shilling's INSIGHT)

Our investment strategies for 2010 follow from our forecast of continued economic weakness and deflation, as discussed earlier in this report and in previous Insights, especially our Dec. 2009 edition. We see the 2010 investment climate dominated by weak economic growth here and abroad, led by U.S. consumer retrenchment. More government fiscal stimulus and continuing Fed policy ease are likely in this setting. So is low inflation or deflation.

INVESTMENTS TO BUY

1. Buy Treasury Bonds. Long-term Insight readers know we started recommending long Treasury bonds back in 1981 when we forecast secular and huge declines in inflation and interest rates. So we declared back then that "we're entering the bond rally of a lifetime." The yield on 30-year Treasurys was 14.7% and our eventual target was 3%. Last year, yields blew through 3% to reach 2.6% at year's end, so in our Jan. 2009 Insight we declared "mission accomplished" and removed Treasury bonds from our recommended list.

But then Treasurys sold off, pushing the yield on the 30-year bond to 4.7% at the end of 2009. So we've reactivated the strategy with our forecast of a return in yields to 3.0% or lower. Treasurys will continue to be a safe haven in a troubled world and benefit from deflation as well as their three sterling features. They are the best credits in the world. They are highly liquid. And they generally can't be called by the Treasury, and calls limit price appreciation when interest rates fall.

A decline in yields from 4.7% at present to 3.0% may not sound like much, but the bond price would appreciate over 34%. If it occurs over two years, then two years' worth of interest is collected, and the total return on the 30-year Treasury would be 44%. On a 30-year zero-coupon Treasury, which pays no interest but is issued at a discount, the total return would be about 64% -- most attractive! Recall that in 2008 when 30-year Treasurys rallied from 4.5% to 2.7%, their total return for the year was 42%..

Treasury bonds way outperformed equities in the 1980s and 1990s in what was the longest and strongest stock bull market on record. The superiority of Treasurys has been even more so since then. Chart 1, our all-time favorite graph, shows the results from investing $100 in a 25-year zero-coupon Treasury bond at its yield high (and price low) in October 1981, and rolling it into another 25-year Treasury annually to maintain that 25year maturity. In November 2009, that $100 was worth $16,972 with a compound annual return of 20.1%. In contrast, $100 invested in the S&P 500 at its low in July 1982 was worth $2,099 in November for an 11.8% annual return including dividend reinvestment. So Treasurys outperformed stocks by 8.1 times!

Doubters

Many believe Treasury yields are headed up, not down. They think that all the bank reserves created by the Fed that have not generated bank loans will do so, flooding the economy with money and then create excess demand and inflation. They also think the continual heavy issuance of Treasurys to fund the nonstop federal deficits will push up yields. In contrast, we don't foresee the rapid economic growth needed to induce chastened banks to lend and cautious creditworthy borrowers to borrow. And if we're wrong, it will take at least several years to eat up global excess capacity during which the ever-inflation-wary Fed will no doubt remove the excess bank reserves, as Fed officials have already indicated.

We do expect large federal deficits for many years, in part because of pressure on government to create jobs and restrain unemployment in a slow growth economy. But those deficits will increasingly be funded by U.S. consumers as their saving spree continues. Although stock market bulls salivate over the prospect that increased saving will mean more equity purchases, we believe most of the money will continue to reduce the immense debt consumers have accumulated in recent decades.

Repaying debt will be attractive to many Americans in 2010 and beyond 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.

Another concern for Treasury bonds is that continued huge federal deficits and the required Treasury financing will erode confidence in these issues by Americans and foreigners, as noted earlier. This seems unlikely, especially before the end of this year. Also, as U.S. consumers save more and curb spending on domestic products and imports, the trade and current account deficits will continue to shrink. Earlier federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade and current account surpluses. The growing U.S. current account deficit measured 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, and further declines will accrue in future years if, as we forecast, exports grow faster than imports. So foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will be financed by rising U.S. consumer saving.

With 3-month treasury bills yielding 0.046%, we've moved out on the yield curve for what is essentially cash positions in some cases. Sure, 5-year obligations are much more volatile than 3-month bills and do have risk of loss if interest rates rise. But we think the direction is down in that part of the interest rate curve, and 2.6% returns vs. 0.046% seem enough to offset the risks.

2. Buy Income-Producing Securities. This includes high-quality corporate and municipal bonds as well as stocks of utilities, consumer product companies, health care firms and others that pay meaningful dividends that are likely to rise. Master Limited Partnerships are also possibilities, but only if their underlying businesses are secure enough to continue significant income flows to limited partners and stockholders. Banks used to pay significant dividends but slashed them when their earnings collapsed. Nevertheless, their deleveraging and reversion to safer but less growth-oriented businesses will probably pressure them to again pay attractive dividends.

Utilities lagged behind the stock market last year, but at the end of November, the dividend yield on utilities averaged 4.5% compared to 2% for the S&P 500 index. That low return compares with 3%, which used to be the floor (Chart 2). Payout ratios recently have been essentially meaningless with the collapse in corporate earnings, but low, 31% in the third quarter of 2009. Under pressure from stockholders, dividend yields are likely to return to 3% or more. The current high level of corporate cash will also encourage dividend paying.. Also, the S&P utility sector has returned 53%, including dividends, since 2000 while the total return on the S&P 500 index has been a minus 11%.

With stocks likely to be weak this year, dividend yields may constitute 100% or more of total returns. Note, however, that although the prices of utility and other defensive stocks sometimes rise in bear markets associated with recessions, that's not always the case. That was clearly true in 2008 when virtually every stock sector went down. Utility and other dividend-paying stocks and ETFs based on them, however, can be hedged against general stock market declines.

3. Buy Consumer Staples and Foods. Items like laundry detergent, bread and toothpaste are basic essentials of life that are purchased in good times and bad. In fact, as we've seen lately, consumers are buying more of their calories in supermarkets and they economize by eating at home rather than in restaurants. Note, however, that they are downgrading from national brands to cheaper house brands, and likely will continue to do so as a weak economy and high unemployment persist. Among retailers, the winners may continue to be discounters. Producers of national brands will need to continue to adapt to consumer downgrading by emphasizing cheaper "value" products.

4. Buy Small Luxuries. This is an investment concept we developed years ago. Consumers, especially when they're hard pressed, tend to buy the very best of what they can afford, even if it's within a low-priced category. We first noticed this tendency years ago, before apartheid ended in South Africa. We read that urban blacks there often carried the elegant, slim and expensive umbrellas typical of investment bankers in London. They couldn't afford cars or maybe even taxi fares, but did achieve status and satisfaction with fine umbrellas. We also learned of a currently unemployed man who enjoyed the status of morning coffee at 7-Eleven six days a week. By reusing his cup and the one he takes home to his wife, he gets a 32-cent discount per $1.37 serving and saves $655 a year on this small luxury.

Companies are adapting to small luxury modes in various ways. Some are offering the same products with lower cost and selling prices. Coach is cutting ladies handbag prices and working with suppliers to reduce costs. Neiman Marcus is pressing suppliers for lower-cost versions of designer styles.

Others are putting their prestigious names on different products. C.F. Martin reintroduced its stripped down 1930s guitar for under $1,000. Average prices were in the $2,000 to $3,000 range and its top of the line guitar sells for $100,000. California winemakers are emphasizing cheaper wines as sales of those over $25 per bottle slump. Consumers are retrenching and dining out less at upscale restaurants where fine wines are sold. Tiffany sales of products over $50,000 are weak, but high-quality small items continue to sell well--always in its trademark blue box. Procter & Gamble has not cut prices on its top of the line products that sell at premiums but carry high-quality images. Consumers still splurge on such small luxuries as Gillette's five-blade Fusion razor and Olay's Pro-X moisturizer. But P&G has introduced cheaper "value" versions of Tide and other products to compete with the growing consumer interest in lower-cost national and house brands.

5. Buy The Dollar. Dumping on the dollar was the favorite sport of investors and the financial media until very recently. The financial meltdown in 2008 drove investors to the dollar as the global safe haven, but in early 2009 that status faded as fears of financial collapse melted. Buck-busters cited the record low short-term interest rates, with the fed funds target rate at 0-0.25%, even lower than in Japan. This made the greenback the preferred funding currency for the carry trade in which it is borrowed and then sold for other higher yielding currencies with rising interest rates. The falling dollar against those currencies enhances the profitability of those trades. Buck dumpers also emphasized the tremendous amount of dollars being pumped out by the Fed and the Treasury 70 in their attempt to revitalize the economy 68 and the Fed's clearly-stated commitment to keep short-term interest rates low for an extended period.

Despite all its drawbacks, however, the dollar remains the world's reserve currency and safe haven, regardless of suggestions by the Chinese and others that the dollar should eventually be replaced by a global currency. This status for the buck appears to be reemerging and will grow if we're right and hopes for a rapid economic recovery are dashed. Furthermore, almost everyone was on the dump-the-dollar side of the boat, a situation similar to early in 2008 that preceded the dollar's jump starting in mid-year (Chart 3). History suggests that when that happens, the winds often shift and all those folks will get tossed into the water as the boat sails in the reverse direction.

We favor selling British sterling since the U.K. economy remains in deep trouble, with even higher external debt than in the U.S.-- a ratio to GDP of 404% in 2008 compared to 95% in this country, which has caused bond rating agencies to threaten a downgrade of U.K. government debt. Also, the troubled British financial sector accounts for 21% of total jobs compared with 14% in the U.S. The U.K. was almost alone among advanced countries in suffering a falling economy in the third quarter of last year.

The euro is vulnerable, in our view, because the eurozone has a one-size-fits-all monetary policy but its economies vary in strength from Germany and the Low Countries at the top to Portugal, Italy, Spain, Greece and Ireland at the bottom. Those lands can't use independent monetary policies to stimulate their economies since that's the providence of the European Central Bank. So they need to resort to fiscal stimuli and increasing government borrowing to finance the resulting deficits. A number have suffered sovereign debt rating downgrades, which increase their borrowing costs, and more are likely. This could spark renewed threats that one or more countries will withdraw from the eurozone and go back to using drachmas, draculas or whatever as their currencies. That probably won't happen as the ECB will do all it can to prevent dissolution, but serious discussion of the likelihood could depress the euro considerably against the dollar.

These concerns are not new for us. Just as the euro was being launched 10 years ago, we wrote in our Dec. 1998 Insight that with a common currency, individual countries would be forced to rely on fiscal policy to deal with local business conditions and "the limit on fiscal stimulus will be default risks. Government bond investors and rating agencies will become the policemen and will blow the whistle.... It's even possible that economic differentials among countries may be so great that the common currency doesn't hold together, especially in the next European recession when unemployment leaps...."

Commodity-driven currencies like the Canadian, Australian and New Zealand dollars are also likely to weaken against the greenback as commodity prices fall. The Japanese economy remains weak and back in deflation, but the yen's involvement I the carry trade makes it a tricky currency for investment.

6. Buy Eurodollar Futures. In most markets, traders want to be where the action is, where liquidity is the greatest even though that's where competition is the strongest. Years ago, a jeweler in New York City complained to us about how fierce the competition was in his location. His shop was on 47th Street between Fifth and Sixth Avenues, the heart of the jewelry district. We asked why he didn't move to a less competitive area. He shrugged and said, "This is where the action is." In the case of short-term credit instruments used in futures trading, eurodollars are where the action is.

Our interest is in eurodollar futures contracts. Eurodollar futures are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future, and for investors to bet on the future direction of short-term interest rates. Each Eurodollar futures contract has a notional or "face value" of $1 million, though the leverage used in futures allows one contract to be traded with a margin of about $1,000. Trading in Eurodollar futures is extensive, and the market for them tends to be very liquid. The prices of Eurodollars are quite responsive to Fed policy, inflation, and economic indicators. It's ironic that eurodollar futures markets dominate trading, not those for Treasury bills or federal funds on which eurodollars are essentially based.

Eurodollar futures prices are determined by the market's forecast of the 3-month US$ LIBOR interest rate expected to prevail on the settlement date. Eurodollar futures contracts extend out for 40 quarters or 10 years, so they can be used to bet on interest rate movements many quarters ahead.

Long positions in eurodollar futures have been one of our most successful investments in recent years. Earlier, the futures market did not price in the full extent of the Fed-engineered decline in short-term interest rates. With our forecast of the financial crisis and the worst recession since the 1930s, however, we believed that the Fed would ease dramatically. So we reasoned that eurodollar futures prices would rise as they reflected the Fed's action. So far, they have.

Now the futures market assumes that the Fed will raise its target rate in the course of this year, so the LIBOR rate on which eurodollar futures settle will increase by 1.22 percentage points between January and December. We, however, believe that a weak economy will keep the Fed on hold throughout this year, so the interest rate implied by the December 2010 contract will fall by 1.22 percentage points. That would result in a $3,050 profit on a $1 million futures contract. That's a mere 0.3% gain. This is hardly worth the investment without leverage. But with only a $1,000 margin requirement on the futures contract, well, you do the math.

INVESTMENTS TO SELL OR AVOID

We hope these six investment strategies for 2010 that involve buying or being long securities are useful. But given our forecast that, at best, the U.S. and global economies will be sluggish this year, it won't be a surprise that we have a longer list of strategies that involve selling or avoiding various sectors. In fact, there are 11, or nearly twice as many.

7. Sell U.S. Stocks in General. The S&P 500 index in late December was selling at 19 times top-down Wall Street strategists' operating earnings estimate of $60.59 per share for this year, as noted earlier. That's an historically high P/E to start with that makes stocks vulnerable going into the year. Even more so because it assumes a steep economic recovery in 2010. And even more so if our forecast of continuing recession or sluggish recovery at best proves out. Our $50 estimate of operating earnings, down 11% from estimates for 2009, puts the S&P 500 index P/E at a nosebleed 22.5 level, as noted earlier.

Selling stock indices short, either through futures contracts or ETFs, strikes us as a prudent idea. Index shorts can also hedge long positions in utilities or other long strategies we discussed earlier.

Be well aware that our forecast of a declining U.S. stock market is critical to many other strategies we'll discuss later that involve selling or avoiding equity sectors here and abroad. We believe they all will perform worse than the stock market overall, but if we're wrong and the stock market leaps this year, we'll probably also be wrong on many of these other strategies.

8. Sell Homebuilder and Selected Related Stocks. Homebuilder stocks rebounded sharply from their March 2009 lows, along with stocks in general, but peaked in September with a slight downward trend since then. This may be beginning to reflect our forecast of another 10% decline in house prices (Chart 4). Excess inventories of houses for sale, the mortal enemy of prices, remain huge. And inventories may rise, even with housing starts at very low levels, as people foreclosed out of their houses double up with family and friends.

Also, a quarter of homeowners with mortgages are under water, 40% of those who took out mortgages in 2006. Increasing numbers of these people are convinced that they'll never regain positive home equity and are abandoning their abodes in favor of renting other houses at lower monthly costs. Still, the subsequent foreclosures on their mortgages will keep them from qualifying for a government-guaranteed mortgage for three to five years and will stay on their credit records for seven years.

Despite leaping mortgage delinquencies, federally-mandated but mostly unsuccessful mortgage modification programs are keeping many houses, especially middle- and higher-priced homes, from being foreclosed and sold--temporarily. Furthermore, the investment tax credit for new and some existing home buyers, which was extended beyond November 2009, is scheduled to expire in April. The overhang of aging new single-family homes available for sale is huge (Chart 5 ). Also note that new residential mortgages are almost entirely dependent on guarantees from government entities such as Fannie Mae, Freddie Mac and the FHA, and they are tightening their credit standards.

Low mortgage rates are a plus, but are only meaningful to those who qualify for loans as lending standards tighten. Most now need to meet the old conservative standards of 20% down, good credit, full documentation of income and assets, etc. And lower borrowing rates don't help underwater homeowners either refinance or buy other houses. Furthermore, rates on large "jumbo" mortgages remain high. Finally, lower house prices don't induce buyers who expect the downward trend to continue and hold out for even-lower prices.

9. Sell Selected Big-Ticket Consumer Discretionary Equities--for two powerful reasons. First, as consumers persist in their saving spree they'll continue to curtail spending on expensive postponeable items. Second, as widespread price declines persist, they will be anticipated. Prospective buyers will wait for lower prices. As a result, excess inventories and unused capacity will mount, forcing prices lower. That will confirm prospective buyers' suspicions so they'll wait for still-lower prices in a self-feeding downward spiral.

Deflationary expectations are clearly at work in the vehicle market. The cash-for-clunkers program generated one-time sales as buyers viewed it as just one more rebate inducement in a never-ending stream. But who would dare announce to a friend that he paid the full sticker price for any car? Of course, deflationary expectations don't work for small, inexpensive items. Suppose you know for sure that toothpaste will be cheaper next month. If you run out, you won't brush your teeth with Ajax while waiting for lower prices before buying a tube.

Even the rich, normally immune to recessions, are cutting back and downgrading. Note the weak sales at Tiffanys, Nordstrom and Saks Fifth Avenue and the poor auction results for Sotheby's and Christie's. A Merrill Lynch study found that the number of people in the world with $1 million or more in investable assets fell from 10.1 million in 2007 to 8.6 million in 2008. Those assets dropped from $40.7 trillion to $32.8 trillion. Their equity holdings fell in step with the S&P 500, about 40%, and their real estate also dropped in value.

Ever since the data series began in 1967, the share of income of the top 20% has trended up while all other shares fell. Note that these are shares, not income levels--which have grown on balance for all quintiles. Studies have found considerable rotation in and out of the various quintiles, with many of those in the top bracket in a given year absent from it in earlier and later years. Still, the drop in purchasing power for many middle-income people in the last year in addition to the collapse in their homes' values has created considerable anger at those at the top.

The equities of most producers of big-ticket consumer discretionary goods and services collapsed in the 2007-2009 bear market, reflecting consumers' buying strike, but have recovered somewhat since March. With our conviction that American consumers have reached a watershed and switched from a quarter century borrowing-and-spending binge to a decade or longer saving spree, we are very suspicious of the sustainability of any rebound in stocks of producers of major consumer discretionary products such as cruise lines and airlines.

10. Sell Banks and Other Financial Institutions. During the financial free-for-all days, large banks moved well beyond traditional spread lending--taking deposits and then lending them with interest rate spreads to cover their costs, loan risks and reasonable profits. They hyped their leverage--and their risk--as they set up off-balance sheet vehicles, engaged in proprietary trading and in the origination of and investment in derivatives. Regulators stood by under the theory that free markets would discipline excessive risk-taking. Both the big banks and the regulators, however, knew or should have known that those institutions were too big to fail and could take the financial system down with them. So those financial institutions were really playing a game of, heads we win, tails we get bailed out.

And fail they did, and bailed out they have been. Many investors seem to believe that's the end of the unpleasantness and now it's back to business as usual. The recent big trading profits by some financial institutions certainly point in that direction as did the stock rebounds until recently. We doubt it, though. The financial sector expanded its leverage over about three decades and its deleveraging will probably consume most or all of the next decade. Big risk-taking CEOs like Ken Lewis at Bank of America are being forced out, sending a clear message to the senior officers who remain.

Stringent, probably excessive regulation is replacing the laissez faire model. Higher capital requirements and other limits on risk-taking will curb bank profitability. So will the limits on executive pay aimed at reducing the incentive to take big risks.

Weak Loan Demand

Furthermore, with slow economic growth, consumer zeal to save and repay debts, and weak capital spending this year, loan demand will likely be weak. In addition, the present steep yield curve makes borrowing cheap deposits and lending long-term at higher interest rates very profitable. But it will probably flatten as the year progresses and long rates fall. Banks, of course, can increase fees on checking and other accounts, but are limited by competition from money market funds and other alternatives.

Also, banks' costs of borrowing in the bond market is well off its highs relative to Treasurys, but still elevated compared to pre-crisis years. The spread now runs over three percentage points compared to about one in pre-crisis days. Much of the cheap debt banks acquired from private markets in earlier years and the government more recently will mature in the next several years and need to be replaced at much higher costs. The maturities for U.S. banks have dropped from 7.8 to 3.2 years in the past five years.

Regional and community banks are also likely to be unattractive investments this year. Ironically, in the go-go days, many of them were unwilling to virtually abandon their underwriting standards to compete with nonblank residential mortgage lenders. So they lent to the commercial real estate market instead. That's proving to be a jump from the frying pan into the fire, as discussed earlier, and is shown by weak demand, falling prices and rising delinquencies. Regional banks have more than their share of the $1.7 trillion in outstanding commercial real estate owned by all banks. These loans constitute 35% of regional banks; total loans, up from 25% in 2000.

Due to bad commercial as well as residential real estate loans, smaller banks are dropping like flies, 140 so far this year (Chart 6 ). Individually, they aren't too big to fail, but collectively they are since they are the primary financers of smaller businesses. Those businesses don't have access to commercial paper and other credit market vehicles and must rely on their local banks for loans--or on the personal credit cards of their owners.

11. Sell Consumer Lenders' Stocks. Consumer lenders' stocks have also rebounded sharply from their March 2009 lows. We were wrong on our strategy of selling them last year, but believe it will work in 2010.

Consumer lenders had their hey day during the long consumer borrowing-and-spending spree. Consumers were trained--and we use that word deliberately--to believe they deserved instant material gratification. Buy now, put it on the plastic card and pay later-- much later--became the norm. And creditworthiness was no problem for credit card issuers and other consumer lenders. They sliced and diced consumers' financial statuses, used sophisticated models to determine payment risks and charged fees and interest rates to fit any risk category.

But their models and analyses inherently assumed that the borrowing-and-spending binge, as well as the ability to repay, would last indefinitely. But then consumers suddenly switched to a saving spree and started to pay down credit card and other debts. Also, heavy layoffs, leaping unemployment and collapsing house prices and inadequate consumer incomes spiked credit card delinquencies. Congress last year restricted credit card fees and interest charges. Also, consumers went on a buyers strike a year ago and cut back on their use of credit, debit and charge cards.

Recent developments are virtually all negative for the credit card business now and for years to come. The cottage industry to help these people deal with their huge credit card debts is exploding in size. As noted earlier, charge cards and debit cards are replacing credit cards as consumers realize they can't trust themselves to restrain debt and need to pay off monthly or accumulate the money in a bank account before spending it. Layaway plans are replacing the buy now-pay later approach. With the switch from a quarter century consumer borrowing-and-spending binge to a long run saving spree, the credit card business has moved from a growth industry to a laggard.

12. Sell Many Low and Old Tech Capital Equipment Producers. Low and old tech producers will remain depressed in a world of chronic excess capacity. When operating rates are low, producers don't need more capacity and worry that revenues, prices and profits won't be adequate to justify even existing capacity. And note that the volatility of the producers of equipment is much greater than that of the users. Auto sales declined by over 47% from their peak in July 2005, but orders for machine tools, automatic transfer lines and other equipment fell much more as auto assemblers and parts makers almost froze orders. Recall as well how the recession-sired excess capacity in airlines has caused massive cancellations and postponements of orders for Boeing's Dreamliner.

Earlier, we discussed our statistical models that explained capital spending. They show that in accounting for the year-over-year change in the equipment and software or in equipment and software plus nonresidential structures components of GDP, thelevel of operating rates is far and away the most important explanatory variable, even more so for the year-over-year change in operating rates. This indicates that even if capacity utilization is growing rapidly, if it remains at low levels as at present, the growth in capital spending will be subdued.

Other variables, such as the year-over-year changes in cash flow, profits and interest costs, were statistically significant in our models, but much less effective in explaining the change in capital spending. These findings are important because many believe that the negative gap between capital expenditures and internal funds is sure to generate a capital spending surge. But our models, based on history, say that with huge excess capacity, that cash flow won't burn holes in corporate pockets. And our models don't quantify and add in the extra corporate caution spawned by today's recessionary climate and financial crises.

Besides the depressing effects of excess capacity, low and old tech companies suffer from ongoing problems. Foreign competition continues to grow as their technology is transferred to China and other cheap production locales. Some suffer rising cost pressures due to lack of productivity gains. High-cost unionized labor forces are sometimes a problem. And many sell into saturated, slow growth markets.

13. If You Plan to Sell Your House, Second Home or Investment Houses Any Time Soon, Do So Yesterday. This strategy has worked for the last two years and will continue to do so if we're correct and house prices nationwide fall another 10%. Sure, prices have been weakest in states like Florida, Arizona, Nevada and California where the biggest bubbles preceded the collapses. But almost every area of the country has experienced price declines (Chart 7 ).

Many owners have tried to wait out the bear market in housing, a technique that worked in earlier years when any price declines were small and short-lived. But huge excess inventories, a flood of distressed sales after mortgage modification attempts are over, depressed incomes and rising unemployment will probably keep sellers plentiful, buyers reluctant and prices falling throughout 2010 and perhaps beyond. In past regional house price collapses, it's taken homeowners a year-and-a-half to give up and throw their houses on the market for whatever they will bring. After the final bottom is reached, house prices will likely mirror inflation, or in future years, deflation as they have historically.

14. Sell Junk Bonds. During the dark days of the financial crisis, the yields on junk bonds leaped to 19.3 percentage points over Treasurys as investors worried about complete financial collapse and widespread defaults among low-grade issues. Triple-C rated bonds, the lowest junk tier, sold at 42.6 cents on the dollar at the beginning of last year.

But the bailout of the big banks and easing of the financial crisis allayed investor fears and junk spreads narrowed. Institutional investors piled in, followed by individual investors, many of whom sought alternatives to low returns on bank deposits and money market funds. So the spread has dropped to 4.6 percentage points, much closer to where it was before the crisis began. Last year, junk bonds returned over 50%, much more than the 25% gain on the S&P 500 index.

Nevertheless, we believe this rally is way overdone. Default rates on junk bonds normally peak late in recessions or in the year after it ends. Also, the default rate may reach or exceed the previous peak in 2002 if the economy remains weak, suggesting major declines in junk bond prices. Furthermore, the value of bonds after default is likely to go lower if the recession drags on, as we forecast. Slow revenue and cash flow growth will make it difficult if not impossible for a number of financially weak and weakening firms to service their bonds and other debts.

15. Sell Commercial Real Estate. As discussed earlier, excess capacity and big refinancing requirements in coming years will continue to plague hotels, malls, warehouses and office buildings. Moody's/REAL Commercial Property Price Index was down 44% last October from its October 2007 peak. Retailers closed 8,300 stores last year, more than the previous peak of 6,900 in 2001. Businesses will continue to cut costs this year, not only by holding down employment and therefore the need for office space, but also by moving in the partitions to fit the remaining people in less space, as mentioned earlier.

Increasing use of telecommuting will also reduce need for office buildings. And more teleconferencing will cut hotel-utilizing business trips, especially after intensified airport security in reaction to the recent terrorist incident in Detroit on Christmas Day. At the same time, frugal consumers will restrain discretionary travel and the hotel and motel use involved. Weak consumer spending will keep mall and warehouse space under pressure.

Some believe that commercial real estate woes may exceed the residential collapse, and they may be right. Commercial tends to be less leveraged but if refinancing isn't available, it may note make much difference how leveraged it is. Also, distressed commercial real estate owners definitely don't have the political sympathy and bailout prospects enjoyed by troubled homeowners. The Fed has set high standards for bailout loans on commercial real estate. Commercial real estate REITs rebounded last year along with the overall stock market (Chart 8 ), but strike us as vulnerable. These leaps combined with plummeting real estate prices have pushed REIT prices to a 25% premium over their net asset values.

16. Sell Most Commodities. Commodity prices rebounded last year and benefited from cheap and available money. Some live in their own worlds. Petroleum is not only influenced by fundamental supply-demand conditions, but also by OPEC decisions. Natural gas prices in the U.S. weakened last year with the recession, but also because of new production technology that unlocked abundant shale gas. The prices of agriculture commodities, including honey, are highly dependent on weather.

In any event, we believe that economic supply and demand will rule most industrial commodity prices this year and result in weakness due to sluggish global business conditions. Also, investors put a record $50 billion into commodities in 2008 but then retreated last year after prices nosedived. They learned the hard way that commodities aren't an asset class but speculations, and may be cautious this year. And the strengthening dollar should depress the prices of the many commodities traded worldwide in dollar terms. We look for falling commodity prices this year. Also, we believe that many commodity-producing companies and their suppliers of equipment and supplies will be unattractive investments as weak demand, excess capacity and soft prices persist. The same is true for economies such as Persian Gulf sheikdoms that depend heavily on petroleum, as witnessed by the financial collapse of Dubai.

17. Sell Developing Country Stocks and Bonds. As late as the end of 2007, most forecasters believed in decoupling. Even if the U.S. economy suffers a setback, they said, the rest of the world, especially developing countries like China and India, would continue to flourish. Indeed, the strength of those economies could even aid the U.S. as they bought more American exports.

We disagreed. We did a study two years ago that found that China was not yet developed sufficiently to have enough people with discretionary spending to support the economy domestically. She remained export-led, with most of those exports going directly or indirectly to U.S. consumers. So, with our forecast of a major retrenchment by U.S. consumers, we predicted big trouble for China. Our analysis revealed that in China, it takes about $5,000 per capita to have meaningful discretionary spending power. About 110 million Chinese had that much or more, but they constituted only 8% of the population. In India, that class was a mere 5% of the population. In contrast, it takes $26,000 per capita in the U.S. to have discretionary spending power and 80% of Americans have at least that much.

Well, as they say, the rest is history. The Chinese and most other developing Asian countries nosedived as U.S. consumers retrenched. But in the wake of China's huge $585 billion stimulus program last year, massive imports of industrial materials like iron ore and copper, jumps in construction of cement, steel and power plants and other industrial capacity, and a pick up in economic growth, many forecasters again believe in decoupling.

We continue to disagree. Sure, some countries such as Brazil were not hurt too severely by the global recession, at least so far. Still, most developing economies depend on exports for growth, and the U.S. consumer has been the biggest buyer of those exports and far and away the globe's biggest spenders. As the American consumer saving spree continues to shrink the U.S. trade and current account deficits (Chart 9), those developing economies will be subdued.

China's economy looks like a house of cards. Her most recent fiscal stimulus not only went into industrial capacity-building but also bank lending-spawned stock market and real estate speculation. But what will utilize that capacity and justify those speculations? The usual outlet, exports, is curtailed by retrenching U.S. consumers. And, as noted, China is not far enough down the road to industrialization for local consumers to fill the gap.

We doubt that the rebounds in emerging market stocks and bonds correctly forecast robust, decoupled economic growth that is sustainable. While the S&P 500 now trades at 20 times earnings over the last 12 months, normally cheaper emerging markets are more expensive. Recently, the Shanghai Composite Index sported a 32 P/E while South Korea's was at 35 and Indonesia's was at 29. And note that the 65% jump in emerging market stocks in 2009 only offset two-thirds of the 54% drop in 2008.

Furthermore, as was made clear by the universal weakness in security markets in 2008, bond and stock markets around the world are highly correlated. With globalization, the days are gone when a globe-trotting sleuth can discover gems in the remote reaches of Asia or Latin America. The similarity of bond and stock performance is even greater when adjusted for risk. Emerging market stocks and bonds may climb more in bull markets, but have greater falls when the bear arrives, as we believe he is about to. There's no such thing as free lunch.

Quarterly Review and Outlook - Third Quarter 2009

John Mauldin — Mon, 12 Oct 2009 20:32:18 GMT

I look forward at the beginning of every quarter to receiving the Quarterly Outlook from Hoisington Investment Management. They have been prominent proponents of the view that deflation is the problem, stemming from a variety of factors, and write about their views in a very clear and concise manner. This quarter's letter is no exception, where they once again delve into the history books to bring up fresh and relevant lessons for today. This is a must read piece.

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

Quarterly Review and Outlook - Third Quarter 2009

Ponzi Finance

The Federal Reserve reported that as of June 30, 2009 total U.S. debt was $52.8 trillion. Total U.S. debt includes government, corporate and consumer debt. Importantly, however, it does not include a few trillion in "off balance sheet" financing, contingent unfunded pension plans for corporate and state and local governments, or unfunded liabilities of the U.S. government for such items as Medicare, Social Security and other programs. Currently GDP stands at $14.2 trillion, so there is approximately $3.73 in debt for every dollar of output in the United States, a level unprecedented in our history (Chart 1). Normally, debt levels as a percent of GDP would be uninteresting and immaterial; however, the current level of debt is unique in two ways. First, the asset side of the balance sheet purchased by the debt is falling in price. Second, the money that was borrowed to purchase those assets was often fraudulently expended. Neither the borrower nor the lender really expected the debt to be serviced. Rather, each party expected the asset price to rise extinguishing the debt.

This type of financial arrangement was correctly analyzed by the famous American economist Hyman Minsky in his paper, "Financial Instability Hypothesis", in which he described three phases of debt financing. The first is "hedge finance", where the lender expects a return on both principal and interest. The second is "speculative finance" where the lender expects to get interest on the loan but perhaps not the principal. The third case, where the lender expects neither the principal nor interest to be returned, is referred to as "ponzi finance". This was typified in the last business cycle by loans issued without documentation, no down payment home loans, extremely low cap rates on commercial real estate, and the high leverage borrowing ratio of private equity funds. Even ponzi finance works as long as asset prices are rising. But once the bubble is pricked, the debtor is left with declining asset values that preclude the rollover of their obligations.

Presently, in this worst of all post-war recessions we are witnessing the collapse of asset prices that were inflated by the speculation of earlier years. The aftermath of that speculation and its impact on the economy has been thoroughly studied prior to our present business cycle by the economists of yesteryear who marveled at the mania in the collective mindset of private citizens and their elected representatives who produced such bubbles. The most famous of these economists was Irving Fisher (1867-1947), who in 1933 wrote about this problem of over-indebtedness (Irving Fisher, 1933, Econometrica, "The Debt-Deflation Theory of Great Depressions"). He stated flatly that over-indebtedness was the difference between normal business cycles (recessions), which occur frequently through "over-production, inventory misjudgment, or commodity price fluctuations" and extreme business cycle fluctuations (depressions). Based on his analysis of the great depressions of 1837, 1873, and 1929 he outlined a pattern of economic developments that will take place when the debt cycle is broken. Seemingly old news, but it is interesting to apply his sequence of events to today's economic developments as there are disturbing similarities.

A Downward Spiral

Fisher posited that debt liquidation leads to distress selling, contracting bank deposits and declining velocity of money, all of which contribute to the fall in price levels. This accurately describes today's circumstances. Distress selling is rampant, with home foreclosures reaching all-time highs. Additionally, rapidly rising foreclosures in commercial real estate are causing the closing of financial institutions and the liquidation of their portfolios. Money supply (M2), an imperfect measure of bank deposits, is essentially flat over the last six months even though the monetary base is 100% higher than it was a year ago (Chart 2). Further, the velocity of M2 has contracted at a 12.7% rate over the past two years. The Personal Consumption Expenditure Deflator (goods purchased by consumers) has fallen from a 2.7% growth rate 12 months ago to a yearly increase of only 1.3% presently, and appears to be heading for a zero reading in 2010. GDP has recorded its greatest contraction since the 1930's, and probably is not yet at its lowest level for this cycle.

Fisher then noticed that this distress selling would lead to a fall in the net worth of businesses, a decline in profits, and a reduction in employment. Fisher may have been talking about 1929 and the 1800's, but that is precisely our present situation. Despite a 19% gain in stock prices this year, the S&P 500 has declined about 30% from its peak and stands lower than it was a decade earlier. Corporate profits are down approximately 13% on a year over year basis, and in 2008 S&P 500 profits fell for the first time since 1933. The net worth of hundreds of banks and other large corporations has fallen below zero, with some surviving only because of a massive rescue effort by the federal government. Despite these efforts, consumer net worth has fallen, price levels of homes are down about 30% from their peak levels, and business net worth has been impaired by an almost 39% decline in commercial real estate from its peak levels. Industrial production is down 13.3% since its peak, the largest 20 month decline in the post war period (Chart 3). Including potential revisions, the U.S. has lost eight million jobs in this recession, and currently 17% of the labor force is either underemployed, partially employed, or out of work seeking employment.

Fisher seems to be not so historical as prescient. He states that all the above problems create disturbances in the rate of interest, particularly the fall of nominal money rates and the rise of real interest rates. The federal funds rate is now effectively zero, and yet with the steady downward movement in price indices, real interest rates are rising. This, of course, is of concern to debtors.

The uncomfortable conclusion of Fisher's analysis is that major business cycle fluctuations are, in fact, caused by over-indebtedness and the fall in asset prices. Our present situation appears to mirror the exact sequence of events that have occurred in previous depressions. This suggests that our current "great recession" may morph into a more serious and elongated downward business cycle.

The Impossible Promise

The federal government's promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro's book, Macroeconomics - a Modern Approach, p. 370). This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.

From a fiscal policy perspective the outlook for economic growth appears to be one of stagnation for several years due to the size of the federal debt, which is expected to rise 35.7% from 2008 levels to 76.5% of GDP over the next ten years according to the Office of Management and Budget (Chart 4). This exercise in government spending is, of course, an exact replica of the Japanese experience from 1989 to the present. Their debt to GDP ratios have gone from about 50% in 1988 to about 178% today, and yet their nominal GDP is no higher than it was 17 years ago, and their employment stands at twenty year ago levels. It is somewhat unsettling that as of the last employment report the United States employed 131 million people, a level that was first reached in 2000, which means the United States has had no net job gains for almost ten years. Indeed, it appears that the fiscal chain around the free market neck is sufficiently onerous to restrain growth for several years. The promise of the government to revive growth through increased indebtedness is, indeed, an impossible promise.

The Hesitant Fed

As Fisher stated, the write-down of debt and distress selling tends to destroy money deposits and lower the velocity of money. Despite the historical evidence of that fact, our current Fed authorities appear to be oblivious to the lessons of the past. Their initial reaction to the liquidity crisis has to be applauded for their heavy work in insuring the liquidity of the financial system. Similarly, the expansion of their bank balance sheet to $2.1 trillion from $1 trillion was the precise reaction needed to counter the emerging deflation of asset prices. However, their actions increased inflationary expectations, and they have encountered a plethora of critics. In responding to this criticism the most recent statistics suggests they are beginning to lose the fight against the deflationary impulses. Consider that the monetary base rose 1000% in the three months ending December 2008, but has been held essentially flat since then (Chart 5).

The Fed's purchases of assets to increase this base automatically created deposits that positively charged the money supply growth to a 15.2% six-month growth rate (Chart 2). If the economy were operating near full capacity, a healthy banking system would take these deposits and multiply them roughly nine times; that circumstance could be inflationary. Unfortunately the banking system is not healthy, as evidenced by the fact that we have closed 95 banks this year, more than the cumulative total of the past 15 years, and another 416 banks are on a list destined to become extinct. With consumers' asset prices falling so rapidly and banks increasingly afraid of failure, banks are more interested in collecting loans than in lending. So with fewer consumers now credit worthy, loan volumes are collapsing. As loans are paid off, deposits are destroyed, and the money multiplier that should stand at nine has gone to zero. This is evidenced by the fact that the six-month change in M2 has fallen to a 1% growth rate, meaning that monetary stimulus is on hold. Get set for negative GDP in 2010.

Dollar Weakness

The inflation outlook from the monetary and fiscal standpoint looks truly deflationary, yet some believe that dollar weakness will reverse this circumstance and create inflation. This is unlikely. First, our imports are about 13% of GDP, and even if the dollar were to halve in value, the price of imported goods would not only have to compete with U.S. producers, but also their price adjustment would have to offset the other 87% of factors included in the pricing indices. Second, unlike the 1930's a 50% decline in the dollar would be difficult to engineer. Fisher recommended to Roosevelt that the U.S. should exit the gold standard, which he did in April of 1933. That was a fixed exchange rate system, and within three months the dollar lost more than 30% against the gold block countries and fell to 60% of its former value within the next five months. This spurred our exports and provided some price inflation (2.9% per year, GDP deflator) for the next four years. Then, in 1937 the tax increases (the next policy mistake) reversed the positive growth rate of the economy and drove price levels and economic activity downward again. However, even with that small period of price increases the overall price level never recovered from the 25% decline that occurred from 1929 to 1933, and thus deflation reigned. Today the declining dollar is a good thing in terms of our trade balance, but the modest change will be insufficient to offset the negative forces of insufficient domestic demand.

Next year the core GDP deflator will fall to zero, with the possibility of negative levels. Likewise, long-term interest rates, which are highly sensitive to inflation, will continue to move toward lower levels. As stated in previous letters, we see no reason why longer dated Treasury interest rates will not mirror those of Japan, which provides a modern signpost for a deflationary environment. Currently the Japanese ten-year note stands at 1.3% with their thirty-year bond yielding 2.1%.

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

Semi-Annual U.S. Economic Outlook: Collapsing On Schedule

John Mauldin — Mon, 15 Dec 2008 18:31:03 GMT

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, you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his 2009 forecast issue 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 the holidays. And enjoy this week's Outside the Box.

John Mauldin, Editor
Outside the Box

Semi-Annual U.S. Economic Outlook: Collapsing On Schedule

(excerpted from the December 2008 edition of A. Gary Shilling's INSIGHT)

The recession is now running on all four cylinders. We're referring to the four phases of the downturn that we identified much earlier and discussed in numerous Insights.

Phase 1, the collapse of the housing sector, touched off by the subprime slime, as we dubbed it, and measured by the ABX BBBindex, started early last year with the $1.8 billion writedown of subprime mortgage securities by big U.K. bank HSBC in February. Phase 2, the spreading of the woes to Wall Street, commenced with the implosion of two big Bear Stearns hedge funds in June 2007. These first two phases are largely financial, and persist today.

Housing Horrors

Housing starts have nosedived from 2.3 million, seasonally adjusted at annual rates, in January 2006 to 791,000 in October, a post-World War II low (Chart 1). Meanwhile, homebuilder sentiment is now at record lows. Leaping foreclosures, among other forces, have pushed up the homeowner vacancy rate. Some of the victims of declining homeowner rates are moving into rental apartments as the bubble years' lure of homeownership fades or they lose their houses. But others are doubling up with friends and family, thereby adding to empty house inventories.

Foreclosure Sales

As lenders spilled foreclosed houses on the market, they were sold for only 70% of the unpaid loan balance in the third quarter compared with 78% in 2007, and losses averaged 44% of the loan balance compared with 29% a year earlier. With about 40% of existing home sales coming from foreclosures, or "short sales" in which the mortgage amount exceeds the house's value, the prices for selling homeowners and builders are forced to decline to compete.

25% More

Existing home prices are down in October 20% from their peak in October 2005 as measured by the National Association of Realtors, and 21% from their second quarter 2006 peak according to the less-upward biased Case-Shiller index (Chart 2). Curiously, a survey found that in the second quarter, 62% of homeowners believed their houses had appreciated in the last year even though 77% had fallen over that time and only 19% had risen, according to Zillow. Another survey found that 91% believe that a house is the best long-term investment. A third poll revealed that 32% think this is a good time to buy stocks, but 51% believe it's a good time to invest in a home. We wonder if that optimism will persist if our long-held forecast of a 37% peak-totrough decline holds.

Underwater

At present around 12 million homeowners, a quarter of those with mortgages, are underwater with their houses worth less than their mortgages. Among those who bought their homes in the past five years, 29% are underwater. If our forecast of a 37% house price fall is reached, about 25 million, or almost half the 51 million with mortgages, will be underwater. Adding in the 24 million who own their houses free and clear, and one-third of the total will be in trouble. The destruction of the American Dream of homeownership for so many people will force a political response, even though the cost of subsidizing their mortgages down to their house values would be about $1 trillion.

Financial Problems

The woes of financial institutions also persist, fed by bad mortgages and increasingly by other troubled assets. The extreme stress on the financial system here and abroad is manifested in two clear ways: first, the consolidation and disappearance of many previously impregnable financial institutions and second, by the need for huge and continuing government bailout in order to preserve the integrity of the financial structure and, hence, the world's economies.

The list of the departed is well known: Bear Stearns, WaMu, Lehman and Wachovia disappeared while Merrill Lynch arranged a shotgun marriage with Bank of America and Morgan Stanley and Goldman Sachs converted to the safety of bank holding companies.

The FDIC recently announced that the institutions it insures had only $1.7 billion in earnings in the third quarter, down from $28.7 billion a year earlier. And financial troubles aren't confined to banks. Many hedge funds have suffered huge losses on their highly leveraged positions this year. And their sales of securities to limit further losses and to meet investor redemptions are adding downward pressure on many markets. In some, assets are down 50% while others are folding their tents and still others are limiting redemptions, only adding to investor restiveness. Redemptions are expected to jump early next year.

Diversification

Many endowment and pension funds have been hard hit, especially those with heavy alternative investments in hedge funds, private equity funds, venture capital, commodities, currencies, emerging market stocks and bonds, real estate, junk securities, etc. Diversification is a great idea -- if it works! But as we've noted continually in Insights for more than 10 years, there are tremendous amounts of hot money flowing around the world. And whether it's managed on the basis of fundamental factors, momentum, technical analysis, etc., it all tends to end up on the same side of the same trade at the same time.

So when stocks get clobbered, as they have since October 2007 (Chart 3), and force out hot money, it will also retreat from otherwise unrelated long positions in, say, grains, to conserve capital. Many institutional investors believe in the Modern Portfolio Theory of diversification, but erroneously thought that alternative investments would have zero or better still, negative correlation with their basic equity holdings. They also became convinced that commodities and foreign currencies were asset classes like equities and bonds, and merited 5%, 10% or 15% of their portfolios. They're learning the hard way that all those correlations have proved to be close to 100% and that commodities and currencies aren't asset classes but speculations.

The Overarching Reality

Washington policymakers do not appear to have understood the overarching reality -- the massive and painful deleveraging of the immense leverage accumulated by the household and private financial sectors over the last three decades (Chart 4). They were also initially preoccupied with a philosophy of non-intervention in the private sector and with concerns with creating moral hazard if they bailed out troubled financial institutions. Furthermore, they've been making up the game plan as they go along. Last summer, Secretary Paulson told Congress that the $700 billion bailout money would be used primarily to buy troubled mortgages and mortgage-related securities from banks. Somehow, that would encourage banks to resume lending, but we never understood how.

A TARP For All

Even though the majority of the $700 billion TARP money is yet to be committed, that total is only a small piece of the $4 trillion-and-counting sum the federal government has made to bail out the financial sector.

Included in that total beyond the $700 billion TARP program is $350 billion in FDIC guarantees on bank-issued debt, and Goldman Sachs, JP Morgan Chase, Morgan Stanley and Bank of America quickly raised $26 billion with Citigroup and Wells Fargo planning to follow. Then there's an estimated $1.3 trillion from the Fed to buy frozen commercial paper, $540 billion to buy commercial paper and other short-term debt from money market funds to stop the run on them, the new $200 billion Term Asset-Backed Securities Loan Facility (TALF) to back credit card, auto, student aid and small business loans and the $600 billion to buy mortgage-backed securities and GSE debt.

Worst Since The 1930s

Of course, in what will probably be the worst financial crisis and deepest recession since the 1930s, it's not surprising that Depression-era bailout structures are being copied. The Reconstruction Finance Corp., instituted by President Hoover in 1932, bought positions in over 6,000 financial institutions to the tune of $50 billion, not adjusted for inflation or the growth of the economy since then. The government got senior voting rights to control these firms and barred dividend payments to shareholders until the government was repaid.

The worldwide recession is redirecting sovereign wealth money homeward. For instance, seven sovereign wealth funds in the Persian Gulf region are expected to lose 15% of their value, or $190 billion, this year, cancelling the likely $198 billion growth in crude oil revenues.

It's interesting that the Fed, with its new commercial paper program, is lending directly to nonbank corporations for the first time since the 1930s. But then the Fed can lend to anyone, you included, under "unusual and exigent" circumstances. The Fed is, after all, the nation's lender of last resort.

And don't worry about the remaining $370 billion in TARP money being committed. Detroit automakers want $25 billion. Homebuilders want money from somewhere for their $250 billion bailout, mentioned earlier. Banks not included in the initial nine to receive TARP money in the form of preferred stock purchases worry that if they don't ask to be included, they'll appear too weak to qualify. Many of the nation's 6,000 small, non-publicly traded banks want their share of the government goodies even though they can't issue preferred shares and warrants.

Spreading Financial Woes

As consumers retrench and eliminate discretionary spending, they are increasingly regarding monthly payments on credit cards, auto, student and home equity loans as discretionary. When it's a choice between putting food on the table or making a credit card payment, financial responsibility is suffering. Delinquencies and charge-offs in these consumer loan categories are mounting with a 9% increase in auto loans 30 days past due in the second quarter vs. a year earlier and an 11% rise in those 60 days overdue.

Even upscale-oriented American Express, where over half its revenues come from fees paid by merchants, is suffering as charge volume falls and delinquencies and charge-offs on its credit cards rise, leaping 6.7% in September from 3.6% a year earlier. Consequently, the firm recently became a bank holding company so it could qualify for TARP money and hopes to get a $3.5 billion infusion. Credit card issuer Capital One has received preliminary approval for $3.55 billion in TARP money. Credit card issuers are also reacting to weakening volume and jumping charge-offs by raising interest rates and fees.

Student loans more than doubled from $41 billion in school year 1997- 1998 to $85 billion in 2007-2008, but almost all of the growth was in private loans, with subsidized federal aid relatively flat. And delinquencies are jumping in that segment. SLM, or Sallie Mae, the largest private student lender, reported a delinquency rate of 9.4% in September vs. 8.5% a year earlier. Parents, suffering from stock losses and the disappearance of home equity, are no longer able to bail out their debt-swamped offspring. Meanwhile, SUV and other vehicle owners who are now upside down on their auto loans due to weak used vehicle prices have limited zeal to keep up on loan payments.

TALF

Adding the general freezing of credit markets to these conditions and it's not surprising that investor buying of securitized consumer loans, which normally provide the funds to make fresh loans, has dried up. In October, there was only one $500 million deal compared to $50.7 billion a year earlier. And the interest cost has leaped. From June to October, the risk premium on a triple A credit card deal jumped from 3.2 percentage points over 2-year Treasurys to 4.67. Treasury Secretary Paulson recently said that that market "is currently in distress, costs of funding have skyrocketed and new issue activity has come to a halt."

So the government bailouts that we predicted in our October Insight have commenced. The Department of Education is buying $6.5 billion in federally-guaranteed loans, which doesn't affect troubled private student loans directly but does bolster the student loan market overall.

Much more importantly, the government in late November initiated the Term Asset-Backed Securities Loan Facility (TALF) under which the New York Fed will extend up to $200 billion in nonrecourse loans to holders of asset-backed securities backed by highly-rated auto, student, credit card and small business loans. The program may be expanded later to include commercial and residential mortgage-backed securities. The Treasury is kicking in $20 billion from TARP to absorb any losses, as noted earlier.

The hope is that this $200 billion infusion will re-ignite consumer loans. But, as discussed in our October report, leaping delinquencies and the eventual huge writedowns by financial institutional holders of bad consumer loan-related securities suggest that the zeal for consumer loans on the part of lenders or investors will remain subdued. Like TARP, TALF is likely to be no more than a bailout for distressed lenders who made a lot of bad loans. Since the Nov. 25 announcement of TALF, yields on bonds backed by credit card and auto loans remain at record levels.

Foreign Financial Woes

Phase 2 of the recession, financial woes, are, of course, a global phenomenon. And so are the responses. The U.K. initiated the direct injection of government money into banks to buy preferred stocks. The British government had hoped to attract some private capital into HBOS and Royal Bank of Scotland, but collapsed share prices left the government with most of the new stock. Barclay's avoided government help, but with its stock down 70% this year, it may ultimately end up with a third of the bank owned by Middle East investors as it raises $10 billion. The Bank of Japan is injecting another $32 billion into the financial system by expanding lending and easing collateral requirements.

Switzerland depends heavily on her reputation as a super-safe haven for international money, and her financial services industry contributes 11.4% to GDP and employs 5.9% of her workforce. Yet the condition of her banks has deteriorated to the point that in October, her Economics Minister had to state publicly that the government would not allow big banks UBS and Credit Suisse to fail. The government is injecting $5 billion into UBS to back $50 billion in illiquid UBS assets. That bank has suffered over $40 billion in losses due to bad mortgage-related securities.

Credit Suisse is in better shape but suffered a $2 billion third quarter loss due to writedowns on mortgage securities and unsold buyout loans as well as currency trading losses. The bank still holds $26 billion in leveraged loans and conventional mortgagerelated securities. Both banks are closing their bond funds for outside investors due to huge withdrawals following losses.

Meanwhile, the Netherlands agreed to inject $13 billion into the banking and insurance giant ING. In 2000, the Spanish central bank introduced its "dynamic provisioning" system that required Spanish banks to build up considerable reserves against potential future losses. As a result, Spanish banks began this year with 200% coverage of nonperforming loans compared with 59% for the average EU bank in 2006. Still, Spain recently set aside $41 billion to fund illiquid assets of her banks. And turbulent market conditions prompted Banco Santander, Spain's largest bank, to unexpectedly announce last month a $9 billion rights issue.

Russia has been floating on a sea of crude oil, but has sunk along with oil prices. Russians are fleeing the ruble for dollars and $83 billion left the country from August to October. The government has raised interest rates and spent heavily to cushion the currency's descent and avoid a repeat of its 1998 collapse. Still, the ruble is down 5% from its August high, and a halving of its current value is forecast. Meanwhile, plunging crop prices and a lack of credit is curtailing Brazil's soaring farm sector.

In Asia, Pakistan, which reluctantly sought a $7.6 billion IMF loan, really needs $10 billion to $15 billion to prevent economic collapse, government officials say. Dubai's pell-mell economic growth has been heavily financed by international debt that may be hard to refinance. South Korea, responding to shortages of foreign currency for her banks and businesses, in October announced a $100 billion government guarantee on foreign currency loans and a $30 billion infusion of dollars into her banks. More recently, that country has problems with high household debt, which leaped from 38% of GDP in 1997 to 66% last year and is probably higher today. And rising credit costs and falling stock and corporate bond prices are slashing the profits of Japanese banks and their ability to provide capital to the international financial system.

Central Bank Responses

Central banks have responded to the global financial crisis in three ways. First, the Fed cut the discount rate and then the federal funds rare repeatedly, starting in August 2007. The Fed has continued this traditional easing approach and other central banks have followed more recently and aggressively, including the European Central Bank, the Bank of England and the central banks of India, China, Australia, Norway, Sweden South Korea, the Czech Republic, Switzerland, Japan and even Indonesia.

Nevertheless, it became clear early on that rate cuts were of limited value since banks were so scared that they didn't want to tend to each other much less customers. The spread between the London Interbank Lending rate on U.S. interbank loans and Treasury bills, which leaped in the summer of 2007, remains wide. Furthermore, central bank rates are approaching zero at which point, as we understand it, they'll stop falling. So the ammunition of rate cuts is almost all shot off. The horse didn't want to voluntarily walk to the water and, besides, the pond is almost empty. Fed Chairman Bernanke recently said, "The scope for using conventional interest rate policies to support the economy is obviously limited."

So the Fed moved quickly to step 2, leading the horse to the water. It introduced a succession of facilities to auction money to member banks, make it available to nonbank government security dealers, etc. The ECB and the Bank of England introduced similar facilities. Last August, the People's Bank of China, her central bank, relaxed credit quotas so most banks can lend 5% more this year and, more recently, allowed local companies to easily sell yuan-denominated debt of three-to-five years' duration. Then China, it increased quotes for state-controlled lenders by $14.5 billion this year, encouraged local governments to support credit guarantee firms and opened new financing channels including loans for mergers and acquisitions and for consumer finance.

India's central bank has repeatedly reduced bank reserve requirements as has China's. And the Fed has attempted to satisfy foreign banks' gigantic demand for Treasurys by mushrooming its currency swap agreements with foreign central banks and then providing unlimited dollars to the ECB, Bank of England and Swiss National Bank for lending to local banks. The top policymakers of the cautious ECB recently called for an "abundant and generalized" capital infusion into banks. But all these central bank efforts resulted in the proverbial pushing on a string. The funds have stayed in the banks and haven't been lent out and entered the money supply to any meaningful degree as banks want nothing but Treasurys. The central banks led the commercial bank horse to water, but he wouldn't drink.

So it's on to step 3 with the Fed and other central banks, as well as governments, investing directly in Fannie and Freddie, AIG, banks, credit card issuers, insurers, etc. here and abroad, buying commercial paper and, most recently, purchasing indirectly credit card, auto, student and small business loan-backed securities and maybe extending later to commercial and residential mortgagebacked securities as well as subsidizing mortgage rates, as noted earlier.

Washington officials cringe at the suggestion that these measures amount to "quantitative easing," the Japanese policy initiated in 2001, because it failed to rapidly spur Japanese bank lending and the economy and arrest deflation. The Bank of Japan drove its target rate to zero with no effect and then tried to hype the quantity of money by buying government bonds, asset-backed securities and even stocks.

Current quantitative easing by the Fed may not be any more successful than it was in Japan since the global financial system is in a classic liquidity trap, as in the 1930s when bankers were defined as people who wanted to lend to those who didn't need to borrow and didn't want to lend to those who did. Today, banks don't want to lend to anyone but the U.S. Treasury.

Consumer Retrenchment

The financial crisis spawned by the collapse of the residential mortgage market and the follow-on Wall Street woes obviously just had to depress the goods and services economy, and it has in Phases 3 and 4 of the unfolding recession. With the collapse in stock prices and evaporation of home equity, consumers have no other meaningful source of borrowing to fund their spending growth in excess of their after-tax income gains. Notice that home equity withdrawals through cash-out mortgage refinancing and home equity loans reached about $900 billion at annual rates, or around 10% of consumer spending. Now it's negative as principal repayment exceeds home equity withdrawals. So consumers' 25-year borrowing and spending binge, as witnessed by their quarter-century saving rate decline (Chart 5) and borrowing rate surge (Chart 6), is over.

In addition, Americans, especially postwar babies, have saved little for retirement as they concentrated instead on spending. The nosedive in stocks has only made retirement prospects more bleak. In the last 15 months, $2 trillion has disappeared from workplace retirement accounts, including 401(k)s, which now are the primary saving vehicle for 60% of employees.

Jobs

As the housing and financial sectors continue to drop and U.S. consumers retrench, layoffs and unemployment will continue to mount. Payroll employment, which fell 533,000 in November (Chart 7), will probably continue to see monthly declines of 500,000 and the unemployment rate will likely exceed 8% by the end of 2009.

Housing and financial services job cuts are already large and more are coming. But job losses have spread well beyond housing and finance. Manufacturing jobs will continue to be lost as consumers buy fewer domestic goods and foreigners buy fewer American-made products. Retail jobs, normally the employment of last resort for the newly unemployed, are shrinking rapidly. Retail trade employs 10% of the total, but since November 2007, accounted for a quarter of jobs lost, or 320,000, as consumers cut their spending. And another 209,000 retail employees had their full-time hours cut to part-time. Estimates are that 6,100 U.S. stores -- ranging from mom-and-pops to major chains -- will fold this year, up 25% from 2007, and followed by 14,000 stores in 2009.

Impotent Monetary Policy

Conventional monetary policy ease through central bank target interest rate cuts at present is nearly useless, i.e., pushing on a string. Qualitative easing, now actively pursued by the Fed and the Treasury and by central banks and governments abroad, will probably at best only stabilize demoralized financial structures by substituting government securities for questionable assets with little near-term rejuvenation of lending and economic activity.

Also, bear in mind that in democracies, governments are almost guaranteed to be behind the curve in dealing with financial and economic crises. That's because voters elect them to respond to their concerns, not to act in anticipation of yet-unseen problems. Politicians are responders, not planners. In 2006, neither voters nor politicians wanted to prepare for a mortgage market collapse, but voters demanded and got swift action after the crisis unfolded in 2007 and this year.

This means that any resuscitation of the global economies falls on fiscal policy and, as usual, the effects will be delayed, influencing the recovery after the recession rather than shortening its normal course. The incoming Obama Administration is, of course, talking about a sizable fiscal package, perhaps $500 billion to $700 billion, or 3.5% to 5% of GDP.

$700 Billion In Perspective

That's a lot compared to the size of post- World War II recessions (Chart 8). Notice that the 1957-1958 recession, the most severe so far, has a peak to trough decline in real GDP of 3.7%, and the long and deep 1973-1975 downturn saw a 3.1% decline. We're forecasting the most severe recession since the 1930s with a 5.0% decline. You may think that a 5% decline is not a lot, but bear in mind that recessions are more interruptions in growth than economic collapses -- growth that business, consumers, employees and government assume will continue without interruption. Similarly, the 21% decline in the Case-Shiller house price index so far (Chart 2) is small compared with the more-than-doubling during the bubble years. Still, it's very painful for those who made small downpayments at the top and those who extracted their equity when prices were still high.

Even a $700 billion fiscal package would probably have limited impact on the recession, and not start to be effective until the end of 2009. And even then, the effects will probably barely offset the negative cumulative recessionary forces. Obama says his proposal will create 2.5 million jobs over two years. But as discussed earlier, payroll declines are likely to continue to run 500,000 per month, so his program would only offset five months of recessionary losses.

Phase 4

Phase 4 of the recession, its globalization, is clearly underway with almost every major country's economy falling whether or not the official recession label has yet been applied. One indicator of weakness is the 2.4% decline in global semiconductor sales in October after a 2.1% fall in September from a year earlier, reflecting softness in computer and cell phone sales. The worldwide turndown is driven by housing slumps, notably in Ireland, the U.K., Spain, Australia and China. U.S. financial woes have spread to almost all major financial institutions worldwide. And consumer spending has been weak in Europe and Japan. U.S. consumer spending accounts for 71% of GDP but less than 60% in all other G-7 countries except the U.K. Sure, much more of healthcare and education expenditures tend to come from government, not consumer pockets in those lands, but households have traditionally been more cautious spenders than Americans, especially in recent years.

And this introduces another key reason for global recession -- retrenchment of U.S. consumers, which depresses U.S. imports on which the rest of the world depends for growth. The huge U.S. trade deficit is the counterpart of the rest of the world's huge surplus.

Commodities

Obviously, the commodities boom is over (Chart 9). Prices of energy, base and precious metals and agricultural products are all down significantly from peak prices. The global recession has reversed the earlier excess of demand over supply.

Also, institutional and individual investors who earlier rushed into commodities under the belief that they are a legitimate asset class like stocks and bonds are stampeding out even faster. The financial crisis has also made investors wary of structured notes and other commoditylinked instruments -- and of the firms espousing them.

Tsunami In The Swimming Pool

As noted at the outset, the first two phases of the recession were largely financial, the residential mortgage collapse and the following Wall Street woes. Then, like a tsunami in a swimming pool, that financial tidal wave rolled to the other side and inundated the goods and services economy, with Phase 3, consumer retrenchment, and Phase 4, global slump. Now the tsunami is being reflected back to the financial side of the pool in three ways.

First, retrenching consumers will keep pushing up delinquencies on credit cards, home equity, auto and student loan debt, which will result in big writedowns for their many institutional holders. Collectively, these four categories amount to $4.4 trillion, dwarfing the $0.7 trillion in subprime loans.

Commercial real estate debt is the second problem area, and of the $3.5 trillion outstanding, $800 billion is in commercial mortgage- backed securities and $2 trillion in commercial mortgages held in regional and community banks. As vacancies rise, big writedowns will follow.

Third is nonfinancial leveraged loans and junk binds. Delinquencies have barely risen from rock bottom levels, but will as anticipated by yield spreads and 20% junk bond yields. Recession-depressed revenues here and abroad, collapsing commodity prices (Chart 9) and the leaping dollar that will turn earlier currency translation gains to losses, will all slaughter the corporate earnings of nonfinancial corporations, so far relatively untouched by the financial recession. So delinquencies and charge-offs of junk securities will leap and many investment-grade debts will be pushed into junk territory. Junk bond spreads vs. Treasurys now imply a 21% default rate, higher than in 1933 at the bottom of the Depression. Financial institutions also own a lot of the $3.7 trillion in leveraged loans and junk bonds.

If the tsunami moving from the goods and services side of the pool does considerably more damage to the financial side, it will again be reflected back and even tighter financing will devastate the real economy. Policymakers here and abroad, of course, are trying to erect baffles in the form of bailouts in the middle of the pool to dampen the waves. They are learning that they have to build those baffles bigger and stronger to prevent the waves washing over them. Their moves from Fed interest rate cuts to massive quantitative easing, described earlier, shows they're making progress.

Recession Ends When?

If policymakers succeed in containing the mortgage mess and bailing out financial crises related to consumer borrowing, commercial real estate and junk securities -- and other financial problems we haven't explained in detail -- then the recession may well end at the end of 2009 as massive fiscal stimulus begins to take hold. If not, it probably will extend well into 2010 and perhaps beyond.

To end the crisis, four developments are needed, in our view. The elimination of excess house inventories will probably continue until at least the end of 2010, as discussed earlier. The writedowns and recapitalizations of financial institutions -- at least those related mainly to mortgage-related problems that have unfolded so far -- are well along.

Subsidizing the mortgages of underwater homeowners is beginning to develop. And of course the quicker the excess house inventories are eliminated, the more limited will be further house price declines and the fewer will be the additional homeowners who will slip under water. Bailouts of bad loans and securities in the three additional areas we've identified are big unknowns in terms of cost and feasibility. Nevertheless, policymakers are gaining experience as they grope their way through the current round of bailouts and may be real pros when further big problems surface.

The Dollar

At the end of last year, we forecast that the dollar would end its seven-year slump and rally later in the year against most currencies, but not the yen. And it did, starting in July. It was obvious a year ago that far too many were negative on the greenback. As with commodities, many institutional and individual investors considered foreign currencies as an asset class, worthy of a certain percentage of their portfolio.

Much more importantly, we were forecasting a major global recession and reasoned that, as usual in times of trouble, the dollar would be the global safe haven. We didn't expect the U.S. economy to improve but that the rest of the world would join America in the tank. The greenback would be the best of a universally bad lot. We expect the dollar to keep rising for the next 5 to 7 years, continuing the long- run pattern.

Profits

With the nonfinancial sector joining financial businesses in full retreat, domestic corporate earnings will be decimated in coming quarters, as discussed earlier. And U.S.-based multinationals will also be clobbered by weak foreign revenues and the strong dollar, which will make foreign earnings worth less in dollar terms. Some 30% to 50% of revenues of consumer staple companies like PepsiCo, Sara Lee and Campbell Soup come from abroad. With our forecast of a severe recession, we look for corporate profits, as defined by the Commerce Department, to fall 48% from their peak in the third quarter 2007 to the fourth quarter 2009, and to drop 32% from 2008 to 2009.

P/Es and Stock Prices

Our forecasts imply S&P 500 operating earnings of $40 per share in 2009, down 35% from our $62 estimate for this year. That may sound extreme, but not for the most severe worldwide financial crisis and deepest global recession since the 1930s. At stock market bottoms, the S&P 500 P/E tends to be in the 10-12 range. But low interest rates normally push up P/Es and 10-year Treasury now yield 2.66%, and will probably be even lower later while 30-year Treasury bonds are now at 3.0%, our long-held target, and also a low in recent decades, but may drop further.

So a P/E of 15 at the stock bottom sounds reasonable, but would put the S&P 500 index at 600 then, down 32% from here and 61% below its record close on Oct. 9, 2007. Wow! Earlier, we warned of the number 777, not the Boeing airliner model but the low on the S&P 500 in 2002. If it were breached, we noted, then the bear market that started in early 2000 would still be intact, and all of the rally from the 777 low in October 2002 to the peak five years later would merely be a rally in a bear market. Last month, the S&P 500 fell below 777. It has since bounced, but probably not for long as new lows lie ahead.

There are other reasons to expect considerable further weakness in stocks. High dividends can support stocks at least to a degree, and dividend yields in Europe are meaningful, averaging 5.2%. But not in the U.S. where the S&P 500 yield is a miserly 2.5%. And dividend cuts are coming fast and furious. In the U.K., dividends are constrained for financial institutions getting government bailouts, while in the U.S., the financial sector is slashing dividends.

Some 36 of the S&P 500 have cut dividends 46 times this year, axing $33.8 billion, with $30.8 billion coming from financials. Among those S&P 500 firms, about 20% of dividends this year are from financials, down from 34% in 2007. Elsewhere, REITs are cutting payouts, and GM eliminated its dividend. Only 202 S&P 500 companies have initiated or raised dividends 218 times this year, representing payments of $18 billion, with only $2.4 billion being from financials. In 2007, 298 did so and only 12 reduced or suspended dividend payments.

In troubled times, investors tend to withdraw from foreign markets to concentrate on the home scene they know best. That's why bear markets tend to be uniform. U.S. investors sold a net $92 billion in foreign stocks and bonds in the July-September period, a record flight from overseas investments, while foreign investors pulled over $100 billion from stocks in Japan, South Korea and India so far this year. U.S. stocks are actually falling less than most foreign markets.

Deflation

For years, we've been forecasting that chronic deflation of 1% to 2% per year would start with the next major global recession. Well, it's here! In October, the U.S. producer price index fell 2.8% from September and the CPI dropped 1.0%, the biggest decline since before World War II. Sure, the big driver was the decline in energy costs, but even excluding food and energy, consumer prices dropped 0.1%.

The Fed worries that in deflation, offsetting monetary policy is difficult since its target rate has to stop declining when it reaches zero. Of course, the Fed has other tools as witnessed by the quantitative easing discussed earlier. Nevertheless, all these measures amount to leading the horse to water, as discussed earlier, and he may not drink. The deflation in Japan in the 1999-2005 years worried the Fed when it appeared imminent in the U.S. early in this decade, and it still does. Japan again faces chronic deflation, and the Bank of Japan forecast zero change in the CPI (ex food but not energy) for the fiscal year ending March 2010. Fed Vice Chairman Kohn said the lesson from Japan was that "we should be very aggressive in combating deflation."

Deflation encourages saving since money is worth more later. It also spawns deflationary expectations. Buyers anticipate lower prices later by waiting to buy. That sires excess inventories and capacity, which forces prices down. Buyer suspicions are confirmed so they wait even further to buy, generating a self-feeding downward price spiral, as now seen in autos and houses. Deflation also elevates the cost of debts and debt service since both remain fixed in nominal terms but the revenues and incomes used to repay them tend to fall with overall prices.

Deflation fears and other forces have also reduced reducing 30-year Treasury bond yields to our long-held target of 3.0% and completed what we dubbed in 1981, when the yield was 14.7%, "the bond rally of a lifetime." The recent financial crisis has also helped as investors abandon everything else -- stocks and fixed income alike -- in favor of Treasurys.

Deflation results from overall supply exceeding general demand. We have been forecasting the good deflation of excess supply, as in the late 1800s and in the 1920s, due to today's confluence of semiconductors, the Internet, computers, biotech, telecom and other productivity-soaked technologies. But we have allowed for the bad deflation of deficient demand, as in the 1930s, if one of two adverse conditions develop -- widespread financial crises and worldwide protectionism. Sadly, both are real possibilities.

Inflation?

Many, of course, worry not about deflation but inflation due to all the money being pumped out by central banks and governments globally. They no doubt are biased since most have lived only in an era of inflation and don't agree with us that inflation is the result of excess government spending in wars, both hot and cold. In peacetime, deflation reigns. Starting with rearmament in the late 1930s, then World War II and the Cold War with its hot phases, Korea and Vietnam, wartime and inflation persisted for 60 years.

For now at least, all that money from central banks and governments isn't getting outside financial institutions. We're in a liquidity trap. The horse isn't drinking, thank you very much. And if lenders do start to lend, central bankers, with their congenital fear of inflation, will no doubt reel in all that extra credit.

Even if the bank reserves stimulate the money supply with the usual multiplier effect, the credit created will pale in comparison to the destruction of derivatives and other privately-created liquidity due to persistent deleveraging and writedowns.

Finally, the consumer saving spree we're forecasting will probably increase the saving rate by one percentage point per year on average for the next decade. That would generate a cumulative $5.5 trillion and go a long way to offsetting the intervening fiscal stimuli, and then some.

When the Chickens Come Home to Roost

John Mauldin — Mon, 10 Nov 2008 23:07:44 GMT

Can the credit crisis get any worse? In this week's Outside the Box my London partner Niels Jensen shows that it indeed can. Banks, and mainly European banks, have large exposure to emerging market debt of all types through both sovereign, corporate and individual loans. Just as banks have had to write down large losses from the subprime crisis and other related problems, next will come a wave of potential losses from yet another source. Niels then goes on to give us a look the size and problems with hedge fund deleveraging. Altogether, this is a very interesting letter and one that is written from a non-US point of view that I think you will find instructive.

Niels Jensen is Managing Partner of Absolute Return Partners based in London, which is a boutique alternative investment firm (www.arpllp.com). You can write Niels at info@arpllp.com if you like with your comments and questions.

John Mauldin, Editor
Outside the Box

When the Chickens Come Home to Roost

The helicopters are here

You may remember my prediction last month that Bernanke's helicopters were on their way. I cannot resist the temptation to show you this chart, courtesy of John Williams at Shadow Government Statistics (see chart 1). The US monetary base has literally exploded in recent weeks and is up a staggering 38% year-on-year - the highest increase since 1939 according to my good friend Simon Hunt at Simon Hunt Strategic Services. Not entirely surprising, you might say. After all, you would expect the Federal Reserve Bank to react swiftly in response to the drama unfolding in front of our eyes.

I just wish we had central bankers here in Europe who would be prepared to move as quickly and as decisively as their colleagues on the other side of the pond. Our 'eurocrats' continue to worry unnecessarily about inflation and, by not acting aggressively enough, it is more than likely that the recession which is engulfing us as we speak will end up doing considerably more damage here in Europe than in the US.

Bank lending is responding

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

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

The canary in the coalmine

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

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

Looking at the evidence produced in a new Goldman Sachs research paper¹, it is primarily Eastern Europe one has to worry about. Credit growth in Eastern Europe and Latin America has been much stronger than in emerging Asia (chart 2).

However, if you then look at the state of the current account (chart 3), it is evident that Eastern Europe is facing a much bigger challenge than the other two regions. Their current account deficit has grown dramatically since the turn of the Millennium and now stands at close to 10% of GDP.

This puts Eastern Europe in a very vulnerable situation. When Asia was in a similar situation back in the late 1990s, it ended in tears with currencies blowing up and consumer spending collapsing. Ultimately, though, it resulted in much improved current accounts as the weak currencies led to an export boom, but there was considerable pain before they got to that point.

Stephen Jen and Spyros Andreopoulos at Morgan Stanley have further explored the subject². They suggest that an already weak banking sector in the OECD could be further stifled by non-performing loans to emerging market countries.

European banks at risk

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

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

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

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

Spain is the Latin juggernaut

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

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

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

Annus Horribilis

Enough said about emerging market risk for now. My other big worry at the moment is what is happening to (some) hedge funds. Clearly, 2008 has been to hedge fund investors what 1992 was to Queen Elizabeth II - Annus Horribilis (see chart 5).

Merrill Lynch did a study recently, showing that the 30 biggest US equity holdings amongst US hedge funds were amongst the poorest performers in the S&P500⁴. In other words, it is likely that much of the recent sell-off in equity markets around the world can be traced back to hedge fund liquidations.

There is no question that hedge funds are downsizing at present. The problem is to obtain precise data on the phenomenon. If we estimate that the global hedge fund industry controls about $2 trillion of capital, and we assume that 15-20% is going to be pulled out between now and year-end (which is not far from the truth according to our sources), $3-400 billion must be returned to investors between now and 31^st December.

Deleveraging continues

That is not the whole story though. The average hedge fund uses leverage, to the tune of about 1.4 times (see chart 6). This is down significantly from a year ago, but it still means that hedge funds need to liquidate investments of at least $500-550 billion in order to meet current redemption requests. And the real number is probably higher because some of the worst performing strategies this year are the ones using the most leverage. The real number is therefore more likely $6-800 billion, and that is a big enough sum of money to put downward pressure on the markets.

Add to this the fact that some hedge funds (mostly the bigger ones) have been selling credit default swaps (CDSs). A CDS is an insurance against corporate default. The buyer of a CDS supposedly makes money if the underlying credit blows up. I say 'supposedly' because the payment is a function of the seller's ability to pay up. That was why Morgan Stanley had to be saved at all cost. MS has been, and continues to be, one of the largest players in the CDS market.

There is no way we can establish precisely how many CDSs hedge funds have on their books, but please consider the following: The CDS market is a $50 trillion market (give or take). Before they blew up, AIG were one of the biggest sellers of CDSs with approximately $500 billion on their books. They ran into problems (partly) because they were heavily exposed to the financial services industry which is already in recession.

Recession in the early stages

The rest of the economy, however, is not yet in recession - or rather, we do not have the statistics to prove it. Corporate defaults are still low, both here and in the US. But corporate defaults will go up as they always do in recessions. If AIG, one of the largest and most sophisticated financial institutions could get themselves into trouble with barely a 1% share of the global CDS market, what will happen to the sellers of the remaining 99%?

Who 'owns' this risk? Is it hedged or not? Is it even possible to hedge the risk, knowing that your counterparty might not be able to pay up? What we do know is that only the larger hedge funds have participated in the practise of selling CDSs. Right now it feels very good not to be invested in those types of hedge funds (as you may be aware, our focus is on alternative investment strategies away from mainstream hedge funds). I also suspect that the extreme volatility in recent weeks is somehow related to this phenomenon. Investor redemptions are not the whole story.

Conclusion

I pointed out several months ago that the world's stock markets would present several 'false dawns' before we could finally declare victory against the bear market. Last week's more upbeat tone was one such 'false dawn', in my opinion. There are three reasons for that:

Firstly, investors have not yet fully capitulated, and that is a necessary condition for markets to turn around. It is best illustrated by a survey conducted by BCA Research at the end of their two-day investment conference held in New York on 20-21^st October. Only five or six of the more than 250 people in the room expected the stock market to be lower a year from now⁵. Not consistent with capitulation! Having said that, it is perfectly normal to experience powerful rallies in the midst of a major bear market. The sharpest rallies in history have actually been bear market rallies.

Secondly, de-leveraging has a long way to run yet, not so much in the hedge fund community where I suspect that much of the damage will be behind us once we pass the next major redemption hurdle on 31^st December, but in society more broadly. Governments, banks, (some but not all) companies and, most importantly, the majority of households are more leveraged than good is. I have borrowed Chart 7 below from BCA Research, and it shows total US bank loans as a percentage of US GDP. Unfortunately, the picture would be much the same for many of the European countries. We are now facing a major de-leveraging cycle and it will suppress economic growth and put a lid on the stock market for years to come.

Thirdly, whereas I fully agree that the worst of the financial crisis might now be behind us, bear in mind that we have not yet seen the full effect of the economic crisis. We are only in the first or second innings of this recession, and the emerging market story has the potential to wreak further havoc. So do credit default swaps - or something else. Recessions are by nature quite unpredictable. There is one thing I am sure about, though. Just as for New Year's Eve, the more extravagant the party, the bigger the hangover. Prepare for this one to linger for a while yet.

Niels C. Jensen

¹Global Economic Weekly, 29^th October, 2008

² "Europe more exposed to EM bank debt than the US or Japan", Morgan Stanley, 27^th October, 2008

³ "Traders warn of Italian iceberg", The Daily Telegraph, 31^st October, 2008

⁴ Source: "Hedge Funds in Trouble", The Economist

⁵ BCA Research Global Investment Strategy, 24^th October, 2008

Where is My Swap Line?

John Mauldin — Mon, 20 Oct 2008 14:58:34 GMT

The G-7 countries now have what amounts to access to the US Fed's window for dollars for their banks. But what of the rest of the world? Brad Setser, an analyst who writes a blog for the Council on Foreign Relations, ask some very interesting questions and points out some big holes in the world economic landscape. If you can't get dollars what does that do to your currency? This contributes to the rise in the dollar against some emerging market currencies. Setser asks: "Where is my swap line? And will the diffusion of financial power Balkanize the global response to a broadening crisis?"

You can read some of his other material at http://blogs.cfr.org/setser/. Setser is an applied international economist with experience at the U.S. Treasury and the International Monetary Fund. Currently examining central bank reserve growth, sovereign wealth funds, and the political implications of emerging market financing of the United States. Author of the recent Council Special Report, Sovereign Wealth and Sovereign Power.

John Mauldin, Editor,
Outside the Box

Where is my swap line? And will the diffusion of financial power Balkanize the global response to a broadening crisis?

Some emerging market central banks have noticed that they - unlike the Bank of Japan, Bank of England, Swiss National Bank and the European Central Bank - don't have access to unlimited dollar credit through reciprocal swap lines with the Federal Reserve.

Peter Garnham of the FT, drawing on Derek Halpenny of Tokyo-Mitsubishi UFJ, observes:

Analysts say the unlimited dollar currency swaps set up between the Federal Reserve and central banks have helped bring stability to currencies through alleviating institutions desire to purchase dollars in the spot market to satisfy overnight funding requirements. "In contrast, the lack of currency swaps put into place between the Federal Reserve and emerging market central banks has likely helped to exacerbate the pick up in emerging market currency volatility" says Derek Halpenny, at the Bank of Tokyo Mitsubishi UFJ.

Think of Korea. There is “a shortage of dollars in the Korean banking system” - and Korean banks (and the Korean government) are scrambling to obtain them. That is likely adding to the pressure on the Won.

For all the talk about how the G-7 has lost relevance, in a lot of ways the recent crisis has reinforced the G-7's importance. Banks in G-7 countries that borrowed in dollars have access to unlimited dollar financing from their central banks - dollar financing that comes from the fact that the main G-7 central banks have access to large swap lines with the Fed.

Banks in emerging market countries have no such luck.

Korea is a highly developed emerging economy. In a lot of ways it already has emerged. But it isn't part of the G-7 (or G-10) and doesn't have a swap line with the Fed that allows the Bank of Korea to borrow dollars from the Fed by posting won as collateral. That means that it has to rely on its foreign currency reserves - and its government's capacity to borrow dollars in the market - to support its banks. Unless, of course, Korea could draw on a set of East Asian swap lines, and effectively borrow from Japan and China.

The old global architecture for responding to financial crises had, in my view, two essential components:

First, the major countries themselves were responsible for acting as the lender of last resort (and the bail-outer of last resort) to their own domestic financial system. Since the advanced economies banks' had liabilities denominated in their own countries' currency (US bank deposits are in dollars, British deposits are in pounds, and so on) this wasn't hard.

And emerging economies had to turn to the IMF (sometimes reinforced with "second line" financing from the G-7) for dollar (or DM or pound or Euro) financing - whether to help meet their government's own financing need, to help the emerging economies' central bank provide a "hard currency" lender of last resort to its domestic financial system or to provide the emerging economy more foreign currency reserves to backstop its currency.

And since emerging market governments often borrowed in dollars or euros rather than their own currencies - and since many emerging market savers held dollar or euro denominated domestic deposits - emerging economies often had a need for significant financing.

This financing though was never unconditional - and was never unlimited. The $35b the IMF lent to Brazil in 2002 and the $20-25b the IMF lent to Turkey in 00-01 seemed big at the time, but it now seems small.

That architecture has been extended in one key way in the crisis:

European and Japanese banks facing difficulties refinancing their dollar liabilities now have (indirect) access to the Fed. The availability of $450b in credit from the Fed allowed European central banks to lend dollars to their banks without dipping into their (comparatively modest) reserves.

Emerging market central banks generally haven't been as lucky. Their ability to lend dollars to their own banks is still limited by their own holdings of dollar reserves, their ability to borrow reserves from the IMF in exchange for IMF policy conditionality and their ability to borrow dollars from other emerging market economies with spare dollar reserves.

I am still trying to figure out how important a change this is - and to assess whether this new architecture makes sense for a global financial system that has changed fundamentally in some ways but not in others.

At one level, the stark divide between banks regulated by a the G-10 countries — which now have access to the Fed as a lender of last resort, albeit indirectly — and the banks regulated by the rest of the world seems a bit anachronistic. The center of the world economy won't always be in the US and Europe.

On another level, a higher level of cooperation is possible among countries with broadly similar political systems than among more diverse group of countries with different political and economic systems. Similar forms of government, broadly similar (though changing) conceptions of the state's role in the economy and a standing political alliance* facilitate the kind of cooperation among G-10 central banks that we have seen recently. Korea could presumably be drawn into the club without changing its basic character - Korea is a US ally and a democracy. Iceland could too, if it patches up its relationship with the UK - though the risk that Iceland's government now has more debt than it can pay makes accepting Icelandic collateral in exchange for dollars a bit more of a problem.

Adding emerging economies with different economic and political systems from the G-7 countries into the “swap line” club might fundamentally change its character. Among other things, the US and Europe basically agree that their currencies should float against each other — and that they should regulate (or, until recently, not regulate) their financial systems in fairly similar ways.

There is another key difference between European banks' need for dollars and many emerging markets' need for dollars. European banks need dollars to finance their holdings of US mortgages and other US securities. If they didn't have access to dollar financing, they would either have to borrow euros and buy dollars - pushing the dollar up (and hurting US exporters) or they would have to dump their US assets (hurting US banks holding similar assets). By lending to European central banks who then lent to their own banks, the US kept some European banks from being forced sellers of risky US assets - and in the process putting pressure on US banks. The US wasn't acting entirely altruistically.

Emerging market banking systems by contrast often need dollar financing not to support their portfolios of US assets but to support their domestic dollar lending.

And it is now clear that a broad range of emerging economies do need access to the international banking system to continue the kind of breakneck growth that they have experienced recently -- and have been caught up in the recent “deleveraging” of the global financial system. The FT's Garnham again:

Analysts said emerging market currencies were being hit as foreign investors pulled money out of developing regions, driven by liquidity pressures from the credit crisis. “There seems little now that the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time,” said Derek Halpenny, at Bank of Tokyo-Mitsubishi.

Hungary is scrambling for euros.

Ukraine's government is scrambling for dollars and euros - both to back its currency and to cover the maturing foreign currency borrowing of its banks.

Pakistan's government needs dollars.

Korean banks are scrambling for dollars.

As are Russian banks. And Kazakh banks. And Emirati banks.

In many of the oil exporters, the government was building up foreign currency assets (reserves, sovereign wealth funds) while the private sector (including many firms with close ties to the government) were big borrowers from the international banking system. In the Emirates there is an added complication: Abu Dhabi was the emirate building up its external assets, while Dubai was the emirate doing the most borrowing.

But across the emerging world, external bank loans have dried up - creating a scramble for foreign currency liquidity.

And emerging markets (and Iceland) are looking for help from a range of sources. Their own central banks' reserves (Korea, Russia, the Emirates) - or the foreign assets of their sovereign fund (Russia, China, Qatar, Kuwait, perhaps Abu Dhabi).*** The IMF, which is clearly back in business. European central banks (Hungary borrowed 5 billion euros from the ECB, the Nordics swap line with Iceland — which was recently tapped for euro 400 million). Russia (if it lends to Iceland).

Or China. Pakistan was certainly hoping that China would offer an alternative to the IMF; China though does not currently seem to be willing to hand Pakistan a sum that is equal to a couple of days of its reserve accumulation ...

This frantic activity suggests another potential change to the global architecture for responding to crises: the IMF no longer necessarily has a monopoly on hard currency crisis lending to the emerging world. It is now one player among many.

That is a fundamentally a reflection of the increased reserves of many large emerging economies.

China clearly has more dollars than in needs to maintain its own financial stability, which means that it is an alternative source of dollar financing. Russia may be too - though the large dollar and euro liabilities of Russian banks and firms implies that its own need for reserves could be quite large. It isn't in as comfortable a position as China.

The diffusion of pools for dollar liquidity available to lend to troubled emerging economies seems at least to me to pose a fundamental issue for the G-7 countries that traditionally have been able to essentially decide on how the IMF's funds are used among themselves: does the diffusion of financial power a major effort to bring the big emerging powers into the IMF's fold - and thus to restore a de facto IMF monopoly on large-scale crisis lending? Or would the cost of any "deal" that would lead that countries like China and Russia and Saudi Arabia (which already has a large IMF quota) channel their lending through the IMF prohibitive?

The right answer isn't clear to me. On one hand, granting the new players significantly more votes might make it next to impossible to build consensus in the IMF - and even a generous increase in the voting weights of key emerging economies might not be enough to convince them to channel their "crisis" lending through the IMF. China might not want to give up on bilateral lending in exchange for say 15% of the IMF's voting shares. On the other hand, China hasn't been keen to throw its reserves around over the past few weeks - preferring the safety of Treasuries to Agencies (or a dollar deposit in Pakistan's central bank) - and might prefer conditional IMF lending to the risk of losing its funds ...

For now it seems to me that the crisis likely has increased the gap between the G-7 (and G-10) countries and the rest of the world in a couple of key ways. Inside G-7 land, US banks could lend in euros (and European banks lend in dollars) secure that they had access to a lender of last resort - and the G-7 countries would still be in a position to offer hard currency loans to their "out-of-area" friends through the IMF. Outside G-7 land, countries would rely primarily on their own foreign currency reserves to cover the foreign currency liabilities of their banks - and potentially could use their own reserves to finance their crisis lending to other troubled countries.**

In some ways, that is a world where the gap between the G-7 countries and the rest would gets larger not smaller ...

* Switzerland is an exception; it stands outside the "Western' alliance but has access to the swap lines. But the Swiss have long been a big part of central bank cooperation - Basle and all.

** This leaves aside a key issue, namely the fact that countries outside the G-7 provide enormous quantities of unconditional dollar financing to the US through the buildup of their reserves. That reserve growth is partially a function of the need for countries outside the G-7 world of reciprocal swap lines to hold a lot more foreign currency - but it is also a function of these countries ongoing policy of pegging their currency to the dollar at an undervalued level. It also ignores the debate over whether sovereign funds investments in the US and European banks should be considered private investments for profit, or part of the global policy response to the crisis.

*** SWF Radar has been invaluable in tracking the use of sovereign funds to support domestic banking systems; many of my links are drawn from there.

The End of the Inflation Scare?

John Mauldin — Mon, 30 Jun 2008 17:34:00 GMT

I mentioned in last Saturday's letter a report by Louis Gave of GaveKal fame on whether inflation may be waning and its importance. Louis gave me permission to use it as this week's Outside the Box. It is typical of the thoughtful analytical work they do.

Louis and his partners and associates at GaveKal write some of the more thought-provoking material I read. They really challenge my position on numerous matters, causing me to look at many items from a different view. That of course, makes this particular piece good for Outside the Box. Whether you agree or disagree, you need to know why you hold a position. If you can't articulate the "against," how can you be sure you truly understand the "for"?

I think given the current debate on inflation, this week's Outside the Box is a must read. While it may look longer, there are a lot of very important graphs here. And thanks to Doug Harrison for helping with the tricky technical aspects of getting this letter out today. It was a lot more than a simple cut and paste, and way beyond my pay grade.

And congratulations to Louis and his wife Kelly who by this time may have a new child. She was due any minute on Friday. I trust you are enjoying your summer. I will be on Larry Kudlow's show tomorrow evening and then having dinner with he and Louis' father Charles (and Tiffani of course). And expect an announcement about a new survey in the next few days.

John Mauldin, Editor
Outside the Box

The End of the Inflation Scare?

by Louis-Vincent Gave

While most economists and strategists spend time worrying about growth, changes in inflation are usually a much greater driver of financial markets than changes in economic activity. This is because:

1- A surge in inflation usually increases volatility of economic growth--which in turn reduces P/Es and the willingness of the private sector to take risks.

2- As highlighted in The Myth of Reverting Margins, inflation typically takes a much meaner bite out of margins than a recession does. As we wrote back then concerning the US growth/margin relationship: "Margins bear little relationship to the level of GDP or consumption growth. In fact, as the economy accelerated from the mid-1960s to the early 1980s, margins plunged. Similarly, as the economy slowed from the early 1980s to the present, margins accelerated... It is inflation, not growth, which wreaks havoc on profit margins (ironically, if everyone has pricing power, no one makes money).

3- Finally, a surge in inflation typically means interest rates will be rising in the near future. Which means that investors get to lose money on both bonds and equities. For example, from 1966 to 1980 (i.e.: the last "inflationary surge" period), US bonds shed -2% per annum and US equities fell -4.9% per year.

Unsurprisingly, given the above, fears are now running high that we may have reentered such an "inflationary bust" period (see The Inflationary Bust Threat). And to be sure, growth almost everywhere around the world is slowing while inflation in almost every country is still accelerating.

Now everyone knows where the slowdown in growth comes from: de-leveraging in the financial sector, overextended consumers needing to tighten their belts, transfers of wealth from the private sector to the public sector through high oil prices, etc... And there are of course myriad opinions as to how long the slowdown will last. But meanwhile, on inflation, our clients seem to be much longer on questions than answers. Where does the current inflation spike come from? How long is it going to last? And can inflation abate without a "Paul Volcker" like monetary policy from the Fed?

In this ad hoc comment, we aim to review some of these questions and, as we always tend to do--answer these questions with yet more questions of our own!

1- Where Does the Inflation Come From?

Just like George Orwell's farm animals, all currencies are equal... though, of course, one is more equal than others. Indeed, the US$ remains the world's reserve currency and, thanks to this status, foreigners cannot impose a particular kind of monetary policy unto the US. As Treasury Secretary Connolly once said: "the US$ is our currency and your problem". And lately, there is little doubt that the US$ has indeed become the world's problem, with its fall in value associated with the spike in commodity prices, which in turn has triggered a sharp upturn in inflation rates all around the world, but especially in the emerging markets (where food and energy represent a much bigger piece of the average family's spending than in most OECD countries).

But of course, the surge in commodity prices cannot be the sole explanation for the recent surge in inflation numbers around the world. After all, an event like the spike in oil prices could also prove to be highly deflationary, since it takes money from the private sector and gives it to the public sector which will typically waste it (i.e.: Chavez financing Castro, Ahmadinejad subsidizing Hamas and Hezbollah, etc...). For a commodity price spike to be inflationary, it needs to be accompanied by excess money creation. If it is not, all that we witness is a change in relative prices across the economy (i.e.: oil prices up, auto and house prices down). This is why Milton Friedman once said that "inflation is always and everywhere a monetary phenomenon" while, around the same time, Jacques Rueff made the observation that "inflation is subsidizing expenditures that give no returns with money that does not exist".

So given that we are now living through a surge in inflationary prices, the questions we should ask ourselves is a) where the excess liquidity creation of recent years has come from? and b) whether excess liquidity continues to be pushed into the system, hereby guaranteeing further increases in inflation in the coming quarters and years?

2- What Explains the Surge in the Amount of Money?

As highlighted above, the US$ is "more equal" than other currencies and, consequently, the Fed holds a "special place" in our current financial system. Undeniably, the Fed is the world's most important central bank and it is thus not that surprising that, as inflationary pressures accelerate around the world, most people are quick to blame the Fed for "falling asleep at the wheel" and allowing money supply in the US to grow unchecked. But is this a valid criticism?

After all, as the charts below highlight, narrow money supply growth in the US (i.e.: the aggregate mostly under the control of the Fed) has not seen much of a rise in recent years (incidentally, the same can be said about Japan and money growth is now decelerating fast in Europe):

While the Fed did print money aggressively between 2002 and 2005 (M1 annual growth was above +5% and sometimes close to +10%), in recent years, the pace of monetary creation has by and large been tame. So the ‘excess money' had to come from somewhere else.

Now as we never tire of pointing out, two sets of players can create money ex- nihilo in our system: central banks and commercial banks. So if the excess liquidity creation has not been the central banks, then the explanation must lie with the commercial banks.

And sure enough, in recent years, banks have ridden the 'financial revolution' as hard as they possibly could and we have witnessed an unprecedented expansion in credit (witness the growth in C&I loans at US banks, red line below):

And, as we now know, money creation off the banks' balance sheets was also, until recently, going strong. Witness, for example, the rapid expansion in corporate paper outstanding in the period between 2003 and 2007 (red line below):

To return to our old favorite, Irving Fisher's equation of MV=PQ, it seems obvious to us that the current increase in P (prices) has more to do with the past few years' extremely buoyant V (velocity) than excessive M (money) growth. A possibility which immediately raises the question of whether velocity will remain as buoyant over the next two years as it did in the 2003-2007 period.

3- Will Velocity Remain As Strong?

As the chart below suggests, the answer to the above question is a simple "No". With bank balance sheets under severe strain, and with bank shares almost everywhere around the world plumbing new depths, an increase in the willingness to take risk from private lenders would be very surprising. And sure enough, after its longest period ever in negative territory, our velocity indicator is once again negative after a brief respite:

This message of slowing private sector liquidity growth is also confirmed when adding the loans at commercial banks with the issuance of commercial paper (for a total private credit growth aggregate--blue line on following page). We have slumped from an annual growth rate of +13% in private credit one year ago to +2.8% today; a level not seen since 2003 (see chart).

So we are now in a situation where a) The Fed is not printing money and b) US financials are de-leveraging rapidly. Thus, if inflation is "always and everywhere a monetary phenomenon", one may conclude that what we are now seeing in the inflation numbers is the echo of the 2003-2007 credit boom, but that looking ahead, the inflation picture should start improving rather dramatically. But such a conclusion would miss out on the other big contributor to global liquidity growth, namely the US current account deficit.

4- The Importance of the US Current Account Deficit

Because the US$ is "more equal" than other currencies in our global system, the US current account deficit plays a specific, and very important, role in our global monetary systems. In essence, the US current account deficit provides the world with its working capital. After all, at any given point, the world needs US$. For example, Nokia needs US$ to pay for the chips it may buy in Taiwan. China needs US$ to pay for the iron ore it buys from Australia and Sweden needs US$ to pay for the oil it buys from neighboring Norway...

This is why, whenever we see an improvement in the US current account deficit, somebody somewhere goes bust. Indeed, when the US exports a lot of dollars, then the rest of the worlds gets used to a "plentiful" liquidity situation... and when the US exports less money, then somebody gets cut off.

So in essence, the current account deficit has always been the mechanism through which the United States could reflate, or deflate, the global economy. When the US current account deficit improved, the US deflated other countries and vice versa.

Now today, the US current account deficit still stands at a rather large 6% of GDP. However, the composition of this deficit has changed dramatically: two years ago, around two-thirds of the US deficit went to non-oil producers and one third was for petroleum products. Today, that situation is inversed to the point where one could argue that, while the US is still reflating oil producing countries (which hardly need it), it is now deflating non-oil producing countries by around 2% of GDP. Moreover, should oil prices start pulling back, we would move extremely rapidly into a situation where the US current account deficit was deflating the whole world (below is a chart we borrowed from The Economist)!

The fact that the US is no longer reflating non-oil producing countries is a very important change in our economies. Indeed, over the past few years, the prevalent belief amongst investors of all stripes has been: a) the US runs a large current account deficit, b) that US interest rates are low, and that, consequently c) the value of the US$ could only fall. And if the value of the US$ could only fall, then borrowing in US$ to finance whatever real estate project, factory, or financial market speculation made perfect sense. This is why, in a number of countries, we started to witness a growth in central bank reserves which far outpaced trade surpluses and foreign direct investment inflows; all of a sudden, a number of large countries started to save more than they earned!

But how can one save more than one earns? The answer, we have argued in the past (see The Surprisingly Strong Growth in Chinese Reserves) is simple: one borrows the difference. As mentioned above, if the perception is that the US$ can only fall against the RMB, INR, VND, MYR, etc... then why borrow in local currency to finance one's capital expenditures or investments? Much better to finance any spending in the ever falling, and cheap to borrow, US$!

So what happens when a Chinese property developer, or a Vietnamese industrialist, borrows US$ to finance his latest project? The first thing he does is that he changes the dollars he does not need for RMB, Rupee, Dong, etc... And, at this point, the foreign central bank has three choices:

1- It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years.

2- It can print money to prevent its currency from rising and then sterilize its FX intervention.

3- It can print money to prevent its currency from rising and just accept the consequences of fast money supply growth (usually higher inflation and asset prices).

And by and large, this is what most nations on the other side of the US current account deficit (i.e.: Asia and OPEC) have done. And unsurprisingly, these are the countries that are today dealing with the largest inflation threats.

We would thus argue that the US current account deficit has been a double inflationary force for the world at large. First, the US current account deficit has pushed a number of countries towards reflation, and secondly, the large US current account deficit has helped propagate the belief that the US$ could only fall, and thus encouraged large borrowings of US$ outside of the US.

And the US current account deficit, combined with the willingness to borrow US$, has been an inflationary force for more than just Asia and the Middle East. It may also explain the surge in money growth in Europe! Indeed, with central bank reserves growing very rapidly around the world (despite a high oil price which, at the very least, should have drained the reserves of Asian and European countries), central banks such as the PBoC or the RBI have likely spent the past few years diversifying their reserves, which for all intents and purposes means buying the Euro... And, as we argued in our book The End is Not Nigh, this "diversification" of reserves means buying European government bonds or, in other words, subsidizing the expenditures of foreign governments with domestically borrowed money.

Et voila! We are now back to Jacques Rueff's definition of inflation being "a policy which subsidizes expenditures that give no returns (i.e.: government spending in Europe or the US) being financed with money that does not exist (i.e.: central bank reserves that have been borrowed, not earned)!"

5- Will the US Deficit Continue to be an Inflationary Force?

Having established that one of the main factors of excess liquidity growth in the world (the willingness of the financial sector to lend very aggressively) had now disappeared, can we rely on the US current account deficit to continue providing excess liquidity to the world. Will an ever growing US trade deficit continue to force other countries to reflate and lead to an ever lower US$? We tend to believe that the answer to that question is a very firm "no". And, this for several reasons:

Reason #1: As reviewed on page 6, the US current account deficit is already improving. Moreover, since oil is now a bigger percentage of the US deficit, should oil prices roll over, we could witness the most rapid improvement in the US current account deficit ever seen. But even without oil rolling over, the recent weakness of the US$ argues for a continued improvement in the deficit:

As does the weakness in US housing:

Meanwhile, the prevalent belief of recent years that borrowing US$ to invest in local currencies was a "no-brainer" is now undergoing a significant test. For example, in recent months, the "long dong" strategy has undeniably failed (the black market now expects a devaluation of over 20% in the Vietnamese currency). The strategy is also failing in India where the Rupee, to many investors' surprise, has been amazingly weak in recent months....

In fact, an interesting development is occurring on the US$: fewer and fewer currencies have lately been rising against the US$ and this despite some pretty poor news from the US (MBIA downgrade, fears on Lehman, weak housing, weak growth, high oil, fears of war with Iran...). Now the typical pattern for an equity bull market is that, as it nears its peak, fewer and fewer shares make new highs even as indices keep on powering ahead. Major corrections are typically preceded by a narrowing breadth... And today, we are undeniably witnessing a deteriorating breath in the "anti-US$" bull market:

To cut a long story short, and with hindsight, the large US current account deficit and the weak US$ were another very potent inflationary force in our system. But, at least at the margin, these inflationary forces should abate, rather than acceler- ate, over the coming months.

6- Conclusion

There is little doubt that, right now, inflation is proving to be a massive headwind for financial markets. And part of that "inflation headwind" is the fear that the Fed, the ECB and other central banks will have little choice but to tighten monetary policy in the coming months. This is most likely true of some central banks, but maybe not all? After all, looking around the world, the inflationary threat is a sure thing in certain regions, and less of a threat in others:

In the US: In a recent paper (see The Dollar's Successful Devaluation), Charles argued that the Fed had just managed to engineer a "good devaluation" for the US$, whereby the currency is brought down without an explosion in monetary aggregates and a rapid acceleration in inflation. This makes the economy competitive and local assets attractive for foreigners. Since then, not much has happened to warrant a change in this view. In fact, since then, the main development has been the roll-over in velocity and renewed fears as to the health of the US financial sector. With velocity plummeting, we think that the bond market is broadly right to not anticipate an acceleration in US inflation.

In Euroland: Just like in the US, the bond market does not seem to really anticipate a massive surge in inflation. And given the very overvalued currency and the inverted yield curve, this makes sense to us.
In the Middle East: The one region of the world which is still experiencing reflation from the US current account deficit is the Middle-East (and to a lesser extent Russia). The unwillingness of policymakers to revalue their currencies (see The Arab Pegs) and the inability of local central banks to sterilize their FX intervention means that the local economies are condemned to continue experiencing inflation as long as they refuse to revalue their currency. More worryingly, a pursuit of the current fixed exchange rate, inflationary policies could lead local economies into the same kind of boom-bust cycle that Vietnam (and maybe India?) are now having to endure.
In India and Southeast Asia: If the US went through a ‘good devaluation' (i.e.: a lower currency without a spike in inflation, triggering an increase in foreign and domestic investments and productivity gains), then it increasingly looks as if India and Southeast Asia have just gone through a ‘bad devaluation' (i.e.: a lower currency which brings about fast money growth, higher inflation, deteriorating trade balances and foreign investor flight). As such, certain countries (India, Vietnam...) are now stuck in the unfortunate position of having to defend their currencies, which is rarely conducive to either economic, or asset price growth.
In China: Inflation is undeniably a problem but, thus far, it seems to be mostly contained to food and energy prices (see A Dummy's Guide to Chinese Inflation). Meanwhile, the only pressures on the RMB are still of a positive nature. Thus, if either the US$ rebounds or commodities roll over (two events that are likely to happen simultaneously), China's inflation problem could dissipate relatively quickly. Chinese and HK shares would then soar.
In Japan, Korea, and Taiwan: Japan, Korea and Taiwan have seen little "hot money" inflows in recent years and have also been better at letting their currencies rise against the US$ (this year, the NT$ is one of the world's best performing currencies with a +6.5% rise while the KRW was one of the best performing Asian currencies between 2004 and 2006). In general rule, these countries today have far less of an inflationary problem than the rest of Asia:

While the markets had started to rally in April and early May, the spike in oil prices fuelled fears of faster inflation and triggered a threat of coming rate hikes from the Fed and the ECB. In turn, all these events weighed down equity markets around the world. However, as we have tried to show in this paper:

The inflation threat is very different between countries. At most risk today are the Middle East, India and Southeast Asia. Meanwhile, inflation is far less of a threat in the US, Japan and North Asia.
Given the fact that the forces behind the recent pick-up in inflation are now turning around (strong willingness to take risk amongst financial firms, growing US current account deficits, overall weakness in the US$), inflation could well start abating in the coming quarters. Moreover, with the turnaround in velocity and the implosion in the banking systems, it seems increasingly likely that neither the Fed, nor the ECB will be willing/have to match their recent hawkishness with rate hikes.
As inflation rolls over in the OECD, the leadership of equity markets should go through a serious adjustment.

Your meditating on inflation analyst,

John Mauldin

How To Fix It

John Mauldin — Mon, 31 Mar 2008 19:21:29 GMT

This week we will look at what will be a fairly controversial essay by good friend Michael Lewitt of HCM. In light of today's speech by Treasury Secretary Henry Paulson of the re-organization of the regulatory system in the US, Michael suggest we...(read more)

Knights of the Round Table: Mapping out the Markets

John Mauldin — Mon, 02 Jul 2007 18:14:00 GMT

Introduction This week in a very special Outside the Box we have an investment outlook tour de force. My friend and South African business partner Dr. Prieur du Plessis gathered a group of some of the more interesting investment managers in the industry...(read more)