Search results matching tag 'Gary Shilling'

A Little Chronic Deflation

JohnMauldin — Sat, 13 Oct 2012 21:46:00 GMT

One of the questions I (and other analysts) get asked most frequently is whether I think there is deflation or inflation in store for the US. My quick answer is "Yes." A brief answer is that we are in a deflationary period and have been for over 30 years, but like all cycles it will come to an end. A great deal of the "when" depends on how the US deals with its deficit following the election. If we put the US on a realistic glide path to a balanced budget (over time) then that deflationary impulse will last longer than most observers think, even given QE3+++. If we do not deal with the issue, and try once again to kick the can to the next election, inflation could be a very real problem.

But one of the definitive experts on the question, and someone who has taught me a great deal over the years, is Dr. Gary Shilling, who has literally written the book (several, actually) on deflation. This week he summarizes a recent client letter for our Outside the Box, and I think you'll will find stimulating. His is not the consensus view, but it's one we need to understand.

You can subscribe to Gary Shilling's Insight for the special introductory rate of $275 for Outside the Box readers (email delivery) and get a copy of the full Insight report excerpted here plus a copy of Gary's latest book, Letting Off Steam, a collection of his commentaries on matters great and small, complex and mundane, serious and frivolous.

Gary will be writing about the details of who will be winners and losers in the Fed's QE3 program, how overseas economies are faring, and what it all means for US stocks and the American economy. To subscribe to Insight call them at 1-888-346-7444 begin_of_the_skype_highlighting 1-888-346-7444 end_of_the_skype_highlighting or973-467-0070 begin_of_the_skype_highlighting 973-467-0070 end_of_the_skype_highlighting and be sure to mention you read about the offer here.

This has been an interesting week. I was supposed to speak at a client meeting for Common Sense Investments at noon on Wednesday in Portland. Kyle Bass of Hayman Advisors was also speaking, so he graciously offered to let me fly with him in his plane rather than catching a redeye the night before. I got up early and made it to the hangar, but the plane had a mechanical problem. A quick call to American Airlines and a mad dash to the airport got me on a scheduled flight that would have gotten me in on time. Except that flight too had issues and the other flights were booked solid. An extremely helpful staff member at American somehow sorted it out and got me onto a full flight (with wifi!) and into Portland in time to let me give a speech as the "closer" for the day. Meanwhile, Kyle was in Chicago and found another way to get to Portland. The other speaker had a personal tragedy to deal with and couldn't make it; so I called my old friend Ed Easterling, who lives not far from Portland, and he kicked the meeting off with his usual dynamic presentation while the rest of us figured out how to get there.

The next day, the founder of Common Sense Investments, Jim Bisenius, took us to his 36,000 acre ranch (and wildlife preserve) in Eastern Oregon to do a little hunting and fishing. It is a rather amazing place. He is such a gracious host and has a gift for getting people to tell their stories. Kyle brought along a young man who had been Special Operations in Iraq and who now carries around about four pounds of metal from a IED that can't be gotten out of him. He's in quite a lot of chronic pain but is rather cheerful and can tell some pretty amazing stories. It makes me humble to realize what sacrifices people make for our freedoms. The courage he and his brethren display on a regular basis is inspiring. I simply stand in awe and gratitude.

I was able to hitch a ride back to Dallas, got in late, got up the next morning, taped videos and read some emails, and then hopped another plane to Houston, where I am getting ready to go to my 40^th Rice University class reunion. I am sure it will be another night of old friends and great stories, so I think I will hit the send button and go on to the party. Have a great week!

Your rather amazed at how much fun I get to have analyst,

John Mauldin, Editor
Outside the Box

Seven Varieties of Deflation

By Dr. A. Gary Shilling

Inflation in the U.S. has historically been a wartime phenomenon, including not only shooting wars but also the Cold War and the War on Poverty. That's when the federal government vastly overspends its income on top of a robust private economy—obviously not the case today when government stimulus isn't even offsetting private sector weakness. Deflation reigns in peacetime, and I think it is again, with the end of the Iraq engagement and as the unwinding of Afghanistan expenditures further reduce military spending.

Chronic Deflation

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

Doubts

Furthermore, many believe widespread deflation is impossible and that rampant inflation is assured in future years because of continuing high federal deficits, regardless of any long-run budget reform. And annual deficits of over $1 trillion are likely to persist in the remaining five to seven years of deleveraging, as I explain in my recent book, The Age of Deleveraging. The 2% annual real GDP growth I see persisting is well below the 3.3% needed to keep the unemployment rate stable. So to prevent high and chronically rising unemployment, any Administration and Congress—left, right or center—will be forced to spend a lot of money to create a lot of jobs.

But big federal deficits are inflationary only when they come on top of fully-employed economies and create excess demand. That's obviously not true at present when large deficits are reactions to private sector weakness that has slashed tax revenues and encouraged deficit spending. Indeed, the slack in the economy in the face of persistent trillion dollar-plus deficits measures the huge size and scope of the offsetting deleveraging in the private sector, as noted earlier.

The deleveraging, especially in the global financial sector and among U.S. consumers, will be completed in another five to seven years at the rate it is progressing. At that point, the federal deficit should fade quickly, assuming a war or other cause of oversized government spending doesn't intervene. The resumption of meaningful economic growth will reduce the pressure for economic stimuli and rising incomes and corporate profits will spur revenues. Serious work on the postwar baby-related bulge in Social Security and Medicare costs will also depress the deficit.

Good Deflation

A decade ago in my two Deflation books, I distinguished between two types of deflation—the Good Deflation of excess supply and the Bad Deflation of deficient demand. Good Deflation is the result of important new technologies that spike productivity and output even as the economy grows rapidly. Bad Deflation results from financial crises and deep recession, which hype unemployment and depress demand.

I've been forecasting chronic good deflation of excess supply because of today's convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output. Ditto for the globalization of production and the other deflationary forces I've been discussing since I wrote the two Deflation books and The Age of Deleveraging. As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. The rapid productivity growth so far this decade is likely to persist (Chart 1).

While I've consistently predicted the good deflation of excess supply, I said clearly that the bad deflation of deficient demand could occur—due to severe and widespread financial crises or due to global protectionism. Both are now clear threats.

My forecast is that the unfolding global slump will initiate worldwide chronic deflation. A number of indicators point in that direction. Sure, much of the recent weakness in the PPI and CPI has been due to falling energy and food prices. Excluding these volatile items, prices are still rising but at slowing rates (Charts 2 and 3). Consumer price inflation is also falling abroad in the U.K. and the eurozone.

After China's huge stimulus program in 2009 in response to the global recession and nosedive in exports to U.S. consumers, the economy revived, but so did inflation. Double-digit food price jumps were especially troublesome in a land where many live at subsistence levels. So in response to the surge in inflation and the real estate bubble, Chinese leaders tightened economic policy, driving down CPI inflation to a 2.0% rise in August vs. a year earlier. But, in conjunction with the weakening in export growth, that is pushing China toward a hard landing of 5% to 6% economic growth, well below the 7% to 8% needed to maintain stability.

Back in the States, inflationary expectations, as measured by the spread between 10-year Treasury yields and the yield on comparable Treasury Inflation-Protected Securities are narrowing.

Other Varieties

Besides rises or falls in general price levels, which most think about when they hear "inflation" or "deflation," there are six other varieties, maybe more.

Commodity Inflation/Deflation. In the late 1960s, the mushrooming costs of the Vietnam War and the Great Society programs in an already-robust economy created a tremendous gap between supply and demand in many areas. The history of low inflation rates for goods and services, we'll call it CPI inflation for short, in the late 1950s and early 1960s, apparently created a momentum of low price advances that kept CPI inflation from exploding until about 1973. But by the early 1970s, commodity prices started to leap and spawned a self-feeding up surge. Worried that they'd run out of critical materials in a robust economy, producers started to double and triple order supplies to insure adequate inventories. That hyped demand, which squeezed supply, and prices spiked further. That spawned even more frenzied buying as many expected shortages to last forever.

At the time, even before the 1973 oil embargo, I was lucky enough to realize that what was occurring was not perennial shortages but massive inventory-building. I found a parallel in post-World War I when wartime price and wage controls were removed and wholesale prices skyrocketed about 30% in one year as double and triple ordering hyped inventories amid frenzied demand and fears of shortages. Then all those inventories arrived and sired the 1920-1921 recession, the sharpest on record, and wholesale prices collapsed. Armed with this history, I correctly forecast the 1973-1975 recession and said it would be the worst since the 1930s, which it proved to be. Arriving inventories swamped production, especially in late 1974 and early 1975, so production nosedived.

Another Commodity Bubble

It's probably no coincidence that China's joining the World Trade Organization at the end of 2001 was followed by the commencement of another global commodity price bubble that started in early 2002 (Chart 4). And it has been a bubble, in my judgment, based on the conviction that China would continue to absorb huge shares of the world's industrial and agricultural commodities. The shift of global manufacturing toward China magnified her commodity usage as, for example, iron ore that previously was processed into steel in the U.S. or Europe was sent to China instead.

Peak Oil

Crude oil has been the darling of the commodity-shortage crowd, and when its price rose to $145 per barrel in July 2008, many became convinced that the world would soon run out of oil.

But they discounted the fact that reserves are often underestimated since oil fields produce more than original conservative estimates. Nor did they expect conventional and shale natural gas, liquefied natural gas, the oil sands in Canada, heavy oil in Venezuela and elsewhere, oil shale, coal, hydroelectric power, nuclear energy, wind, geothermic, solar, tidal, ethanol and biomass energy, fuel cells, etc. to substitute significantly for petroleum.

Recent Weakness

The weakness in commodity prices, starting in early 2011, no doubt has been anticipating both a hard landing in China and a global recession. In my view, the foundation of the decade-long commodity bubble is crumbling, and the unfolding of a hard landing in China and worldwide recession will depress commodity prices considerably, even from current levels, as disillusionment replaces investor enthusiasm.

Wage-Price Inflation/Deflation. A second variety of inflation is a particularly virulent form, wage-price inflation in which wages push up prices, which then push up wages in a self-reinforcing cycle that can get deeply and stubbornly embedded in the economy. This, too, was suffered in the 1970s and accompanied slow growth. Hence the name, stagflation. As with commodity inflation, it was spawned by excess aggregate demand resulting from huge spending and the Vietnam War and Great Society programs on top of a robust economy.

Back then, labor unions had considerable bargaining strength and membership. Furthermore, American business was relatively paternalist, with many business leaders convinced they had a moral duty to keep their employees at least abreast of inflation. Most didn't realize that, as a result, inflation was very effectively transferring their profits to labor. And also to government, which taxed underdepreciation and inventory profits. The result was a collapse in corporate profits' share of national income and a comparable rise in the share going to employee compensation from the mid-1960s until the early 1980s.

The Peak

The wage-price spiral peaked in the early 1980s as CPI inflation began a downtrend that has continued. Voters rebelled against Washington, elected Ronald Reagan and initiated an era of government retrenchment. The percentage of Americans who depend in a significant way on income from government rose from 28.7% in 1950 to 61.2% in 1980, but then fell to 53.7% in 2000. Furthermore, the Fed, under then-Chairman Paul Volcker, blasted up interest rates, and negative real borrowing costs turned to very high positive levels.

As inflation receded, American business found itself naked as the proverbial jaybird with depressed profits and intense foreign competition. In response, corporate leaders turned to restructuring with a will. That included the end of paternalism towards employees as executives realized they were in a globalized atmosphere of excess supply of almost everything. With operations and jobs moving to cheaper locations offshore and with the economy increasingly high tech and service oriented, union membership and power plummeted, especially in the private sector.

In today's unfolding deflation, the wage-price spiral has been reversed. Contrary to most forecaster expectations, but forecast in my two Deflation books, wages are actually being cut and involuntary furloughs instituted for the first time since the 1930s. In inflation, oversized wages can be cut to size by simply avoiding pay hikes while inflation erodes real compensation to the proper level. But with deflation, actual cuts in nominal pay are necessary. Note that as wage cuts and furloughs become increasingly prevalent, the layoff (Chart 5) and unemployment numbers (Chart 6) will increasingly understate the reality of the declines in labor compensation.

Financial Asset Inflation/Deflation. Perhaps the best recent example of financial asset inflation was the dot com blowoff in the late 1990s. It culminated the long secular bull market that started in 1982 and was driven by the convergence of a number of stimulative factors. CPI inflation peaked in 1980 and declined throughout the 1980s and 1990s. That pushed down interest rates and pushed up P/Es. American business restructured and productivity leaped.

A Secular Down Cycle

The robust economy upswing that drove the 1982-2000 secular bull market ended in 2000, as shown by basic measures of the economy's health. Stocks, which gauge economic health as well as fundamental sentiment, have been trending down since 2000 in real terms (Chart 7). At the rate that deleveraging worldwide is progressing, it will take another five to seven years to be completed with equity prices continuing weak on balance during that time. Employment also peaked out in 2000 even after accounting for lower although rising labor participation rates by older Americans. Household net worth in relation to disposable (after-tax) income has also been weak for a decade.

The Federal Reserve's Survey of Consumer Finances, just published for 2007-2010, reveals that median net worth of families fell 39% in those years from $126,400 to $77,300, largely due to the collapse in house prices. Average household income fell 11% from $88,300 to $78,500 in those years with the middle-class hit the hardest. The top 10% by net worth had a 1.4% drop in median income, the lowest quartile lost 3.7% but the second quartile was down 12.1% and the third quartile dropped 7.7%.

Households reacted to too much debt by reducing it. In 2010, 75% of households had some debt, down from 77% in 2007, according to the Fed survey. Those with credit card balances fell from 46.1% to 39.4% but late debt payments were reported by 10.8% of households, up from 7.1% in 2007. With house prices collapsing, debt as a percentage of assets climbed to 16.4% in 2010 from 14.8% in 2007. Financial strains reduced the percentage that saved in the preceding year from 56.4% in 2007 to 52% in 2010.

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

As a result, the speculative investment climate spawned by the dot com nonsense survived. It simply shifted from stocks to commodities, foreign currencies, emerging market equities and debt, hedge funds, private equity—and especially to housing. Homeownership additionally benefited from low mortgage rates, loose lending practices, securitization of mortgages, government programs to encourage home ownership and especially to the conviction that house prices would never fall.

Investors still believed they deserved double-digit returns each and every year, and if stocks no longer did the job, other investment vehicles would. This prolongs what I have dubbed the Great Disconnect between the real world of goods and services and the speculative world of financial assets.

Treasurys

I hope you'll recall my audacious forecast of 2.5% yields on 30-year Treasury bonds and 1.5% on 10-year Treasury notes, made at the end of last year when the 30-year yield was 3.0%. Those levels were actually reached recently (Chart 8), and I now believe the yields will fall to 2.0% and 1.0%, respectively, for the same reasons that inspired my earlier forecasts. The global recession will attract money to Treasurys as will deflation and their safe-haven status. Sure, Treasurys were downgraded by Standard & Poor's last year, but in the global setting, they're the best of a bad lot.

The deflation in interest rates has spawned significant side effects. It's a zeal for yield that has pushed many individual and institutional investors further out on the risk spectrum than they may realize. Witness the rush into junk bonds and emerging country debt. Recently, investors have jumped into the government bonds of Eastern European countries such as Poland, Hungary and Turkey where yields are much higher than in developed lands. The yield on 10-year notes in Turkish lira is about 8% compared to 1.4% in Germany and 1.6% in the U.S.

The inflows of foreign money has pushed up the value of those countries' currencies, adding to foreign investor returns. And some of these economies look solid relative to the troubled eurozone—Poland avoided recession in the 2008-2009 global financial crisis. But the continuing eurozone financial woes and recession may well drag the zone's Eastern European trading partners down. And then, as foreign investors flee and their central banks cut rates, their currencies will nosedive much as occurred in Brazil.

Tangible Asset Inflation/Deflation. Booms and busts in tangible asset prices are a fourth form of inflation/deflation. The big inflation in commercial real estate in the early 1980s was spurred by very beneficial tax law changes earlier in the decade and by financial deregulation that allowed naïve savings and loans to make commercial real estate loans for the first time. But deflation set in during the decade due to overbuilding and the 1986 tax law constrictions. Bad loans mounted and the S&L industry, which had belatedly entered commercial real estate financing, went bust and had to be bailed out by taxpayers through the Resolution Trust Corp.

Nonresidential structures, along with other real estate, were hard hit by the Great Recession and remain weak as capacity remains ample and prices of commercial real estate generally persist well below the 2007 peak. The two obvious exceptions are rental apartments and medical office buildings. Returns on property investments recovered from the 2007-2009 collapse, but are now slipping.

Retail vacancy rates remain high (Chart 9) due to cautious consumers and growing online sales. Rents remain about flat. Ditto for office vacancies due to weak employment and the tendency of employers to move in the partitions to pack more people into smaller office spaces. The office vacancy rate in the second quarter was 17.2%, the same as the first quarter, down slightly from the post-financial crisis peak of 17.6% in the third quarter of 2010 but well above the 2007 boom level of 13.8%. In the second quarter, office space occupancy rose just 0.12% from the previous quarter compared to 0.18% in the first quarter.

Housing Woes

House prices have been deflating for six years, with more to go (Chart 10). The earlier housing boom was driven by ample loans and low interest rates, loose and almost non-existent lending standards, securitization of mortgages which passed seemingly creditworthy but in reality toxic assets on to often unsuspecting buyers, and most of all, by the conviction that house prices never decline.

I expect another 20% decline in single-family median house prices and, consequently, big problems in residential mortgages and related construction loans. In making the case for continuing housing weakness, I've persistently hammered home the ongoing negative effect of excess inventories on house sales, prices, new construction and just about every other aspect of residential real estate.

Spreading Effects

That further drop would have devastating effects. The average homeowner with a mortgage has already seen his equity drop from almost 50% in the early 1980s to 20.5% due to home equity withdrawal and falling prices. Another 20% price decline would push homeowner equity into single digits with few mortgagors having any appreciable equity left. It also would boost the percentage of mortgages that are under water, i.e., with mortgage principals that exceed the house's value, from the current 24% to 40%, according to my calculations. The negative effects on consumer spending would be substantial. So would the negative effects on household net worth, which already, in relation to after-tax income, is lower than in the 1950s.

Currency inflation/deflation. We all normally talk about currency devaluation or appreciation. This is, however, another type of inflation/deflation and like all the others, it has widespread ramifications. Relative currency values are influenced by differing monetary and fiscal policies, CPI inflation/deflation rates, interest rates, economic growth rates, import and export markets, safe haven attractiveness, capital and financial investment opportunities, attractiveness as trading currencies, and government interventions and jawboning, among other factors. In recent years, Japan, South Korea, China and Switzerland have all acted to keep their currencies from rising to support their exports and limit imports.

The U.S. dollar has been strong of late, resulting from its safe haven status in the global financial crisis. Furthermore, the U.S. economy, while slipping, is in better shape than almost any other—the best of the bunch. I believe the global recession will persist and the greenback will continue to serve this role. Furthermore, the greenback is likely to remain strong against other currencies for years as it continues to be the primary international trading and reserve currency. The dollar should continue to meet at least five of my six criteria for being the dominant global currency:

1. After deleveraging is complete, the U.S. will return to rapid growth in the economy and in GDP per capita, driven by robust productivity.

2. The American economy is large and likely to remain the world's biggest for decades.

3. The U.S. has deep and broad financial markets.

4. America has free and open financial markets and economy.

5. No likely substitute for the dollar on the global stage is in sight.

6. Credibility in the buck has been in decline since 1985, but may revive if long-run government deficits are addressed and consumer retrenchment and other factors shrink the foreign trade and current account deficits.

Inflation By Fiat. Way back in 1977, I developed the Inflation by Fiat concept, which gained media attention in that era of high wage-price inflation. This seventh form of inflation encompassed all those ways by which, with the stroke of a pen, Congress, the Administration and regulators raise prices.

The continual rises in the minimum wage is a case in point. So, too, are high tariffs on imported Chinese tires. Agricultural price supports keep prices above equilibrium. As a result, the producer price of sugar in the U.S. is 28 cents per pound compared to the 19 cents world price. Federal contractors are required to pay union wages, which almost always exceed nonunion pay, as noted earlier, another example of inflation by fiat.

Environmental protection regulations may improve the climate, but they increase costs that tend to be passed on in higher prices. The Administration says its new fuel-economy standards of 54.5 miles per gallon by 2025 will cost $1,800 per vehicle but industry estimates put it at $3,000. The cap and trade proposal to reduce carbon emissions is estimated to cost each American household $1,600 per year, according to the Congressional Budget Office. Pay hikes for government workers must be paid in higher taxes sooner or later, and can spill over into private wage increases—although state and local government employee pay is moving back toward private levels, as discussed earlier. Increases in Social Security taxes raise employer costs, which they try to pass on in higher selling prices.

There was some deflation by fiat in the 1980s and 1990s. One of the biggest changes was requiring welfare recipients to work or be in job-training programs. That reduced the welfare rolls from 4.7% of the population in 1980 to 2.1% in 2000, while the overall number that depended on government for meaningful income dropped from 61.2% to 53.7%. But now, as an angry nation and left-leaning Congress and Administration react to the financial collapse, Wall Street misdeeds and the worst recession since the Great Depression, the increases in government regulation and involvement in the economy have been substantial. And with them, more inflation by fiat—at least unless there is a major change of government control with the November elections.

(Excerpted from Gary Shilling's INSIGHT newsletter. For more information, visitwww.agaryshilling.com)

2012 Investment Themes

JohnMauldin — Tue, 10 Jan 2012 03:00:00 GMT

As my good friend Gary Shilling says, in leading off his piece on 2012 investment themes, which is this week’s OTB, “This year is just the first step in the long-run journey that will continue to be dominated by The Age of Deleveraging” – which also just happens to be the title of Gary’s latest book. Whether you call it that or call it the End Game, as I have, it shapes up as a profoundly different and challenging era for all of us. Gary identifies 9 causes of slow global growth in the years ahead:

1. U.S. consumers will shift from a 25-year borrowing-and-spending binge to a saving spree. This will spread abroad as American consumers curtail the imports of the goods and services many foreign nations depend on for economic growth.

2. Financial deleveraging will reverse the trend that financed much global growth in recent years.

3. Increased government regulation and involvement in major economies will stifle innovation and reduce efficiency.

4. Low commodity prices will limit spending by commodity-producing lands.

5. Developed countries are moving toward fiscal restraint.

6. Rising protectionism will slow—even eliminate—global growth.

7. The housing market will be weak due to excess inventories and loss of investment appeal.

8. Deflation will curtail spending as buyers anticipate lower prices.

9. State and local governments will contract.

Gary has always been prescient in looking ahead – witness his call nearly a year ahead of the Great Housing Debacle that commenced in ’07 – but you don’t just want to know what’s coming, you want to know what to do about it; and that’s exactly what Gary is going to run down for you, sector by sector and asset by asset, in the following pages.

I note that this piece is just an excerpt from the January issue of Gary’s INSIGHT newsletter. OTB readers can get the entire 48-page tour de force, and a full year’s subscription, plus the Jan. 2013 issue as a bonus, for $275 via email, by calling them at 888-346-7444 or 973-467-0070. Be sure to mention Outside the Box to get the special rate and free issue.

Now let’s check out Gary’s investing themes for the coming year.

Your antsy about 2012 analyst,

John Mauldin, Editor
Outside the Box

2012 Investment Themes

(excerpted from the January 2012 edition of A. Gary Shilling's INSIGHT)

Our investment themes for 2012 are based on our economic, financial and political outlooks for this year as well as on our long-term forecast. After all, this year is just the first step in the long-run journey that will continue to be dominated by The Age of Deleveraging, as discussed in detail in our recent book with that title. This age, which began in 2007 and probably has another five to seven years to run, is dominated by the unwinding of the immense debt—built up by financial institutions globally starting in the 1970s, by U.S. consumers commencing in the early 1980s and, more recently, by governments as recession-weakened revenues and immense fiscal stimuli hyped their deficits and borrowing.

This and eight other forces (Chart 1) are likely to hold U.S. real annual GDP growth in future years to 2%, compared to the zero growth since the fourth quarter 2007 business peak and the 3.7% annual growth in the 1982-2000 salad days.

2012 Outlook

The 2007-2009 U.S. recession, the deepest since the 1930s, was the start of the worldwide deleveraging and the severe recession now unfolding in Europe is another important component. Like the U.S. Great Recession, the eurozone slump combines a financial crisis and a goods and services downturn. And it may be more severe in Europe where the eurozone, like the U.S., has a common currency and monetary policy but unlike America, lacks a common fiscal policy to deal with the mess.

This year, we also look for a hard landing in China with real GDP growth dropping back to 5% to 6% annual rates, well below the 8% needed to provide jobs for new labor force entrants. We’re also forecasting a moderate recession in the U.S. as consumers retreat from their recent spending strength that flies in the face of declining real incomes. In sum, we expect a global recession this year. A 2012 recession starting from a fourth quarter 2011 business peak would commence four years after the previous top in the fourth quarter of 2007. That would be a bit longer than normal for the secular downswing that we believe commenced in 2000. In the previous 1969-1982 downswing, complete business cycles averaged 3.7 years in length.

2012 vs. 2011 Investment Themes

Our 2012 list of investment themes (Chart 2) is quite similar to our 2011 list (Chart 3) since most still appear valid. Last year, 15 of our themes proved correct and four were not. Treasury bonds were stellar performers, income-producing securities gained as did the stocks of small luxury companies. The dollar rose and Eurodollar futures had another outstanding year. The stocks of healthcare providers rose as did the prices of rental apartments. Productivity enhancers also had a good year.

Among our unfavorable investment themes, homebuilders’ stocks fell as did house prices. Big-ticket consumer discretionary equities fell as did bank stocks, developing country equities, commodity prices and the equities of many old tech capital equipment producers.

Contrary to our expectations, the stocks of North American energy producers fell overall as a result of weakness in natural gas and coal producers. Consumer lender stocks rose, the reverse of our forecast, as did junk security prices and developing country bonds.

This year, we’ve added two new themes: a favorable stance on consumer staples producers and an unattractive forecast for developed country stock markets. At the same time, we’ve had to say goodbye, sadly, to our long-time immense winner, Eurodollar futures. Earlier, the futures market did not price in the full extent of the Fed-engineered decline in short-term interest rates.

2012 Investment Themes

Here is an outline of our 20 investment themes for 2012. Subscribe to INSIGHT for the special introductory rate of $275 via e-mail, and you'll receive the full January 2012 report with all the details for each of the themes.

1. Treasury Bonds Are Still Attractive. Once again, we’re deliberately listing this theme first, not because of nostalgia, although it has worked for us for 30 years on balance, and has been our most profitable investment over those three decades. Instead, it’s because we expect further appreciation with 30-year Treasury bonds, and because so few other investors believe our forecast has any chance of being realized. Fundamentally, we favor Treasury bonds

—Because we foresee slow economic growth at best in coming quarters and years

—Because the Fed is determined to further reduce long-term interest rates

—Because deflation is looming

—Because long Treasury bonds are attractive to pension funds and life insurers that want to match their long-term liabilities with similar maturity assets

—Because as the U.S. moves ever closer to the slow growth and deflation of Japan and her domestic financing of government debt, the parallel trends in government bond yields seem likely to persist

—Because Treasurys are the safe haven in a sea of trouble in the eurozone and elsewhere

—Because China’s attempts to cool her economy will probably precipitate a hard landing

—Because the likely price appreciation in Treasurys is in stark contrast to expensive stocks and overblown and vulnerable commodities, foreign currencies, junk securities and emerging market stocks and bonds.

A year ago, we forecast a drop in the yield on the 30-year Treasury bond from the then-4.4% to 3%. The 3% yield was indeed reached and even breached in late 2011, providing a splendid 33% total return on a 30-year coupon-paying Treasury.

We’re now predicting a further decline to 2.5%, the low reached at the end of 2008 after Lehman’s bankruptcy, because of the similar financial crises in Europe today and the possible spillover to the U.S. That further rate decline would produce a 10% total return in one year on a 30-year coupon Treasurys and 12% on a zero-coupon bond. We also expect the 10-year Treasury note yield to drop from the present 1.87% level to 1.5%, but the total return would only be 5.2%, largely due to its shorter maturity.

The disdain among many investorsfor bonds, especially Treasurys, persists despite their vastly superior performance vs. stocks since the early 1980s. Starting then, a 25-year zero-coupon Treasury, rolled into another 25-year annually to maintain the maturity, beat the S&P 500, on a total return basis, by 9.2 times(Chart 4). This is one of our very favorite charts since we have actually participated in this marvelous Treasury bond rally as forecasters, portfolio managers and investors.

2. High-Quality Income-Producing Securities Continue to be Attractive. We continue to favor high-quality income-producing securities this year for several reasons. Many other investments such as stocks in general are unlikely to provide meaningful returns, especially on a risk-adjusted basis. Furthermore, after the bloodbath for almost all securities in 2008, many individual as well as institutional investors prefer highly-predictable cash returns here and now as opposed to pie-in-the-sky capital gains in the wild blue yonder. Treasury bonds are still attractive for appreciation, but with little appreciation likely elsewhere, investors will likely continue to seek meaningful interest and dividend payments.

After a long hiatus, companies that pay substantial, predictable and increasing dividends may be coming back into style for two distinct reasons. First, in a post-Enron/Arthur Andersen world and after gigantic write-downs made reported earnings for many companies questionable, a company paying meaningful dividends is, in essence, assuring investors that it is generating the real earnings and real cash flow needed to finance those dividend checks.

Furthermore, a significant dividend-payer will almost certainly continue to be run in a prudent and stable manner. Dividend cuts forced by the down phases of volatile earnings patterns are not loved by investors, as was shown when many financial institutions slashed or eliminated their dividend in 2008. Second, dividends may provide the lion’s share of earnings for many companies in future years, as discussed in The Age of Deleveraging. Since the 2000 peak, the S&P 500 lost 18%, but was up 2% after accounting for dividends.

We look for a return to the earlier floor of a 3% dividend yield on the S&P 500 from the recent 2.2% level even though that will put pressure on many companies to hike their dividends. The way the math works out, the dividend yield multiplied by the P/E equals the payout ratio, the percentage of after-tax profits paid in dividends. A dividend yield of 3% multiplied by the current P/E of 14.5 implies a payout ratio of 44% vs. 29% at present. That's a big jump, but would still be below the post-World War II average of 50%.

Furthermore, a number of firms have plenty of free cash to hike their payouts substantially. Big banks’ dividends will probably be limited by the Fed for some time. But meaningful dividend-payers among utilities, consumer product companies and healthcare firms may be attractive. Some have dividend yields that are significantly higher than their bond yields.

Bear in mind, however, that substantial dividend yields do not consistently protect their payors' stocks for declines in overall bear markets. Our earlier study of sector stock performance in bear markets associated with recessions found that sometimes, but not always, equities in significant dividend-paying sectors resisted the general decline in stocks.

3. Small Luxuries Remain Attractive. Consumers, especially when they’re hard-pressed as many are now, tend to buy the very best of what they can afford, even if it’s within a low-priced category. We think manufacturers and retailers that can adapt to the demand for small luxuries will continue to be winners in the current environment. Some are adopting the small luxury mode by offering essentially the same products at lower prices by cutting their manufacturing costs.

Last November, including the kickoff of the Christmas retailing season, U.S. consumers skimped on restaurant meals, groceries and building materials to buy electronic gadgets and other small luxuries. Champagne sales were probably up about 15% during the holiday season, but Emeric Sauty de Chalen, President of a French online wine store, is selling bubbly as a distraction from hard times rather than a celebration. Champagne “is a means to escape everyday life,” he says.

4. Consumer Staples and Foods May Be Attractive Relative to the Stock Market. The S&P Consumer Staples Sector Index’s total return was up 14% last year (Chart 5) and is likely to do well this year, at least relative to stocks in general. Items like laundry detergent, bread and toothpaste are basic essentials of life that are purchased in good times and bad, and we believe their producers' equities will be attractive relative to stocks in general in 2012. So we're adding this as a new investment theme.

Consumer downgrades are likely to continue while the weak economy and high unemployment persist. Proctor & Gamble, which prides itself on selling premium products at premium prices to cost-insensitive customers, has been induced to introduce Gain dish soap that is half the cost of its premium Dawn Hand Renewal. P&G has also seen the market shares of cheaper Luvs diapers and Gain detergent do better since the recession began than its high-priced Pampers and Tide.

Among retailers of consumer staples, the winners may continue to be discounters, including dollar stores. American used-merchandise stores have been thriving. Producers of national brands will need to continue to adapt to consumer downgrading as weak incomes and high unemployment persist by emphasizing cheaper “value” products.

5. The Dollar Should Continue to Appreciate, Especially Against the Euro But Also Against Commodity Currencies Like the Australian and Canadian Dollars as Well as the Mexican Peso. Last year, the greenback fell against the euro early in the year but then rallied sharply, starting in August, as the unfolding financial crisis and impending recession in the eurozone drove hot and cold money to the safety of the buck. On balance, the dollar rose 3% vs. the euro. The dollar index, with a 58% euro weight, was up 2%. With similar patterns, the U.S. dollar rose 0.2% against the Australian dollar and 2% vs. the Canadian dollar but jumped 13% compared to the peso.

The dollar in the long run is likely to remain the world’s primary international trading and reserve currency because of rapid growth in the U.S. economy and in GDP per capita, promoted by robust productivity growth. Furthermore, the U.S. has the world’s biggest economy and its financial markets are broad, deep and open. There are also no substitutes for the buck in the foreseeable future. And the dollar, despite the recent downgrade of Treasurys by Standard & Poor’s, retains considerable credibility. In addition to these long-run factors, the greenback is the global safe haven in the current worldwide sea of trouble. We continue to note that the U.S. economy, fiscal policy and financial markets aren’t all that attractive, but they’re a lot better than the alternatives.

6. Selected Healthcare Providers and Medical Office Buildings Remain Attractive. Last year, the Dow Jones Select Health Care Providers Index rose 10%. Health care is a huge sector, accounting for 17.6% of GDP and growing rapidly. Two major features of the current system almost guarantee explosive growth. First, most Americans don’t pay directly for their health care, which is primarily financed by employer-sponsored insurance or the government through Medicare and Medicaid. Second, in pay-for-service plans, medical providers have many incentives to perform extra work because more office visits and procedures enhance their incomes. Defensive medicine involving more procedures is also encouraged to avoid litigation over real or alleged mistakes.

In addition, the demand for medical services in the U.S. will mushroom over coming decades due to several factors including, among others, an aging population; technological advances that are driving patient demand for more medical services; 32 million more Americans being covered by health insurance under the new healthcare law; more healthcare jobs; and cost control pressures.

We also favor investments in medical office buildings (MOBs) that these increases and shifts in demand will require. This includes related outpatient facilities such as ambulatory care facilities, surgery centers, ambulatory surgical centers, and outpatient cancer and wellness centers. MOB demand is forecast to expand 19% by 2019, 11% of it due to the new law and the rest from population growth. The 64 million square feet are required to meet the demand of the new law and compares with a 2010 build of 7 million square feet. MOBs are much less volatile than other commercial and residential real estate, as shown by more stable vacancy and cap rates. They will not be plagued in future years by persistent excess capacity, which hinders new construction, as is the case with residential real estate, malls and office buildings.

7. Rental Apartments Are Still Attractive, and last year our index of apartment REITs gained 14%. This year we look for further gains in rental apartment prices and securities related to them. Rental apartments will continue to benefit from the separation that Americans are beginning to make between their abodes and their investments. The two used to be combined in owner-occupied houses back when owners believed house prices never fall, and they hadn't since the 1930s. So they bought the biggest homes they could finance. The collapse in house prices has shown them otherwise. A further 20% weakness in the prices of single-family houses due to the depressing effects of excess inventories will add fat to the fire.

It will take a surprisingly small shift in housing patterns to make a big difference in the demand for and construction of rental apartments. Today, there are 114 million housing units in the U.S., of which 38 million are rented. If only one percent of total households decided to move to rented units, the demand for rentals would increase by over one million, most of which would need to be newly built apartments, after current vacancies are absorbed. This is a big number compared to new apartment starts of 333,000 on average over the past 10 years. To put it another way, each 1% decline in the homeownership rate increases rentals by more than one million, to the extent those ex-homeowners don’t double up.

Rental apartments will also appeal to the growing number of postwar babies as they retire, downsize and want less responsibility and more leisure time.

8. Productivity Enhancers Remain Attractive. Last year, the AMEX Computer Technology Index rose 2% (Chart 6). We look for further growth this year in these and other productivity enhancers as business pressure to cut costs persists.

In the ongoing slow economic growth and deflationary environment, increased profits through price and volume increases is difficult, if not impossible, for many firms. So the current cost-cutting zeal will remain in place. Labor cost-cutting has been in vogue in recent years, but does have its limits. So anything—high tech, low tech, no tech—that helps customers reduce costs and promote productivity will be in demand.

9. We Still Favor North American Energy, even though the companies involved had mixed stock performances last year, with a 3% decline in the Dow Jones US Select Oil and Exploration Index. With cheap natural gas and rising pollution problems, coal producers were down in the 50% range. As you might expect, natural gas producers’ stocks were down with falling gas prices, but pipelines, in growing demand, were up. Domestic oil producers fared well but oil sands operators had mixed performances. Energy services stocks fell.

Nevertheless, we remain fans of conventional North American energy because of the national resolve to reduce imports from unreliable foreign sources. Our favorites include natural gas producers, pipelines, oil sands, energy services, oil producers, nuclear energy, shale oil and gas, and maybe even coal. At the same time, we remain skeptical of ethanol, biofuels, wind, solar, geothermal, electric vehicles and other renewable energy activities because of their continuing heavy dependence on government subsidies. The recent bankruptcies of 10 solar panel producers make this point clear.

10. Major Country Stock Markets Appear Unfavorable in 2012. This new theme reflects our forecast of a major recession in the eurozone and the U.K., a hard landing in China and at least a moderate recession in the U.S., all culminating in a turndown in global economic activity accompanied by financial crises of unknown depth. Reinforcing this conviction is our belief that the U.S. and other developed economies are in a secular downswing that started in 2000, which is accompanied by a secular bear market in equities. These periods of more frequent, deeper recessions are mirrored by more frequent deeper cyclical bear markets in stocks.

As noted earlier, since the peak in 2000 until late Dec. 2011, the S&P 500 index has fallen 17% and is only up 3% when dividends are included. We estimate that S&P 500 operating earnings will be $80 next year and that the P/E will drop to 10 in the global recessionary climate. So the S&P 500 index will fall to 800, we believe, a 36% decline from its 1,257 level at the end of 2011. Few agree with these forecasts. Bottom-up Wall Street analysts, who estimate earnings company-by-company and are congenitally optimistic since they want to please the managements of the companies they follow, see 2012 operating earnings at $106.81, a 10.0% jump from the $97.05 they expect for 2011. Even more sober top-down strategists expect a 6.6% rise from $98.90 to $105.38. And most Wall Street wizards believe the current P/E is on the low side, suggesting even more robust expectations for stock prices.

11. Home Builders and Related Companies Remain Unattractive. Last year, the Dow Jones US Select Home Construction Index dropped 9%. It may drop even more this year with our forecast of a further decline in median single-family house prices over the next several years, as excess inventories work their woes. True, new construction is now so low that it can’t drop much further and some single-family home builders are turning their attention to the attractive apartment construction market. Nevertheless, the looming resumption of foreclosure and other distressed sales will depress prices below most home builders’ costs, killing their sales and forcing them to take big writedowns on inventories of houses and, especially, land. Since building costs don’t change much over time, the volatility of house prices is really the magnified volatility of the cost of the land they sit on.

Conditions now are far different than when home building was a growth industry in the salad days of low mortgage rates, lax underwriting standards, securitization of mortgages that passed seemingly creditworthy but in reality toxic assets on to unsuspecting buyers, laissez-faire regulation, and, most of all, conviction that house prices never fall. Now all these conditions have reversed with lending standards tighter, on balance, in part because lenders are being forced to take back bad mortgages. Furthermore, the securitization of mortgages is essentially dead, with government agencies the only buyers. They now provide about 90% of new residential financing.

12. If You Plan to Sell Your House, Second Home or Investment Houses Any Time Soon, Do So Yesterday. If we’re right and house prices have another 20% to fall over the next several years after already declining 33% for a total drop of 46%, this approach is obvious. Sure, it’s tempting to believe that all real estate is local and the only three important factors are location, location, location. But as the decline so far has demonstrated, prices can and have fallen nationwide for the first time since the 1930s. Almost no place in the U.S. was exempt from the sell-off.

13. Many Big-Ticket Consumer Discretionary Companies Remain Unfavorable. Last year, our index, which contains cruise lines, auto producers, high-end consumer electronics, recreational vehicles and resorts and casinos but not airlines, fell 12%. The NYSE Arca Airline Index dropped 31%. We look for more of the same this year as consumers retrench after their Christmas shopping spree. They have to, with real incomes falling (Chart 7). Otherwise, their elevated debt level will rise and the recently-depressed saving rate will fall further.

14. Consumer Lenders Still Look Unattractive even though their stocks rose last year as they benefited from faster consumer spending and more credit card transactions. The consumer retrenchment and global recession we foresee this year, however, should easily reverse those effects.

Cash and debit cards are replacing credit cards as consumers realize they can’t trust themselves to restrain debt and need to 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-long consumer borrowing-and-spending binge to a long-run saving spree, the credit card business has moved from a growth industry to a laggard.

15. Banks Remain Unattractive. Deleveraging and the carryover from past financial woes continue to plague major U.S. banks and financial service institutions, with the Dow Jones US Select Financial Sector Index falling 20%. Regional banks on the Dow Jones US Select Regional Bank Index dropped 12%. We expect further weakness this year as deleveraging and writedowns persist in a recessionary climate. European banks are in much worse shape, plagued by subprime sovereign debt holdings much as U.S. banks in 2007-2009 were sunk by subprime mortgage assets. As with major U.S. banks back then, bailouts of major European banks seem inevitable, and is already the de facto case with many relying also entirely on the European Central Bank for funding.

Stringent, probably excessive regulation in and beyond the new financial reform bill is replacing the laissez faire model. The Fed’s bank supervisors have switched from saying yes to almost anything the banks want to do to saying no. 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, especially after the recent flurry of big bonuses.

Big banks are also being forced to delever and exit profitable businesses that lie outside traditional low-risk and low profit commercial banking activities such as spread lending. They’re being bereaved of off-balance sheet vehicles, proprietary trading and other much more lucrative activities. Although the“Volcker Rule” prohibiting banks from trading for their own accounts has not been fleshed out by regulators, many financial institutions are already taking action to limit or eliminate proprietary trading. They include JP Morgan, Credit Suisse and Goldman Sachs.

Big banks are also forced to repurchase flawed mortgages. U.S. banks have considerable exposure to the continuing eurozone crisis. Profit gains from reducing loan loss reserves and selling non-core assets are probably about over. The restrictions on credit and debit card charges will eat into profits.

In the go-go days, many smaller banks were unwilling to virtually abandon their underwriting standards to compete with nonbank residential mortgage lenders. So they lent to the commercial real estate market instead, often residential construction-related firms that went bust. And they suffered from the housing collapse. Due to these bad commercial as well as troubled direct residential real estate loans, many smaller banks remain in difficulty. Individually, they aren’t too big to fail, but collectively they are since smaller banks 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, often backed by the home equity of their owner, if they have any, or on their personal credit cards.

16. Junk Securities Remain Vulnerable, even though they rose 6% in price last year. In the ongoing zero interest rate world, investors rushed to junk securities in their zeal for higher yields. That drove the spread between junk bonds and Treasurys from its 20 percentage point peak in December 2008 almost back to the previous low of June 2007. In 2009, junk bonds’ appreciation and interest returns combined were 57.3% with a further 15.3% gain in 2010. As in earlier boom times, investor zeal made refinancing sub-investment-grade securities easy, so defaults in the first half of 2011, at 0.2%, were also near record lows. Refinancing money was so readily available that defaulting on junk securities took real skill!

We’ve always felt that junk bonds are essentially stocks. Real, for-sure bonds are backed by so much corporate cash flow that the prospects of interest payments not being met are extremely low. Only with fallen angels destined for bankruptcy do investors worry about getting their semiannual interest checks. By contrast, junk bond price levels and likelihood of meeting interest payments depend primarily on companies’ quarter-by-quarter earnings and cash flow. That’s no different than what principally determines stock prices and dividends.

Sure, stock bulls point out the prospects for growing earnings and stock appreciation, which isn’t the case with bonds unless interest rates decline. Still, in the slow growth, deflationary world we foresee, growth in earnings and stock prices will be limited, hardly enough to give equities a clear advantage.

So let’s look at junk bonds as low-quality equities with big dividend yields, and assume that their spread versus Treasurys measures their market value, dividend yields, and ability to continue their high dividend payments. From this standpoint, these dividends don’t seem big enough to offset the risks that they won’t be paid in the climate we foresee. Slow economic growth robs many financially weak companies of volume expansion, and deflation kills their pricing power.

If junk bond yields rise substantially, however, they then could be attractive in a world in which investors are likely to be interested in meaningful dividends of various kinds. That assumes that buyers view junk not as bonds with temptingly high interest yields, but as low-grade equities with large but risky dividends and little prospects for capital appreciation.

17. Emerging Country Bonds Are Unattractive, despite their rise of 8% last year. Like junk bonds, investor zeal for yield propelled them, and they bounced back late in the year from the European financial crisis scare last summer. Emerging country bonds and junk securities are both risky. Some bond managers who don’t believe that junk yields are high enough to justify the risk have switched to emerging country debt. Are they jumping from the frying pan into the fire?

Investors in emerging country bonds apparently believe in the decoupling myth that says developing countries can grow rapidly and independently from advanced lands that buy their economy-driving exports. That concept flourished before the Great Recession, died with it but was subsequently resurrected. But the recent weakness in stocks globally and in most developed and developing country currencies against the dollar are again challenging the decoupling argument.

Many investors not only invested in emerging country bonds, but in the bonds denominated in local currencies, not the U.S. dollar, in the past two years in search of even higher interest returns. That pushed up currencies, to the detriment of exports, and aggravated inflation in countries such as Indonesia, Turkey, Hungary and Brazil. But with the renewed European financial crisis last summer, the dollar leaped, many of those currencies nosedived and bond investors fled. As a result, bond yields leaped in countries such as Turkey and Hungary. Expect this retreat to persist in 2012 as the global recession unfolds and, as usual, investors retreat to the safety of their home markets, which they understand best, and to the U.S. dollar and Treasurys.

18. Emerging Country Stocks Remain Vulnerable after plunging in 2011. The MSCI Emerging Market Stock Index dropped 20% (Chart 8) and the Shanghai Composite itself fell 22% (Chart 9). Further substantial weakness is likely this year for two distinct reasons.

First, the hard landing in China, the result of government policy restraint there and flagging exports, will knock growth back to 5% to 6% recessionary rates, as China suffered in early 2009. The effects will spread widely from the world’s second largest economy and major commodity importer. Second, the likely major recession in Europe, hard landing in China and economic downturn in the U.S. will spawn global economic retreat to the extreme detriment of commodity and other export-dependent developing economies. The reality of their close coupling to the U.S. and Europe will probably be painfully obvious visible this year.

19. Commodities Will Probably Continue to Decline in 2012 as they did last year. The CRB broad commodity index was down 7%. Agricultural commodities such as sugar and cotton fell from their early 2011 peaks and declined for the year as a whole. Corn prices were about flat in 2011, but wheat and soybeans fell. Copper dropped 23%, no doubt anticipating a global decline in industrial production since copper is found in almost every manufactured good, as well as a hard landing in China, which consumes 42% of annual copper production.

We doubt that the commodity price decline in 2011 fully anticipated the global recession we foresee this year, so further significant declines are probably in store, especially for industrial commodities. Copper prices are still about 85% above the marginal cost of production, so further big price declines are likely before any supply is curtailed. Agricultural commodities, of course, depend on weather. Earlier bad weather, however, did not forestall price weakness last year. And in the past, ideal growing weather often follows bad weather, and bumper crops and huge surpluses replace hand-wringing shortages in a crop year or two.

We certainly hope for good weather next spring for the nectar that our honeybees turn into honey. Still, despite the lousy weather in our area last spring and devastating winter losses that forced us to replace 88 of 89 hives, we still had a decent 2011 honey crop.

20. Old Tech Capital Equipment Producers Remain Unattractive. This group is distinguished from productivity enhancers because their output is mainly used for capacity expansion, not cost-cutting. Our index, which includes makers of industrial construction and agricultural equipment, fell 6% last year (Chart 10). Further weakness this year is likely because of still-ample industrial capacity and moribund construction. Poor exports are likely due to faltering foreign economies, which is important for many of these multinationals.

In this country, many expect the atmosphere of higher profits and piles of corporate cash will unleash a bonanza in capital equipment spending, reversing the ongoing decline in growth rates. Our analysis suggests otherwise. When operating rates are low, as at present, producers don’t need more capacity and worry that revenues, prices, and profits won’t be adequate to justify even existing capacity.

Absolute Zero

JohnMauldin — Tue, 27 Sep 2011 01:12:00 GMT

It was Gary Shilling – way back in the last century – who first woke me up to the real whys and wherefores of deflation, with his 1998 best-seller, Deflation: Why it's coming, whether it's good or bad, and how it will affect your investments, business, and personal affairs. I had read various works on deflation, but nowhere was it put together as well as Gary did it. He followed it up the next year with Deflation: How to survive and thrive in the coming wave of deflation, and in that one he strongly urged his readers out of the stock market – just ahead of the 2000 dot-com bubble burst. But Gary has been so right over the past three decades. (He recently updated Deflation with The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. It’s on Amazon at http://www.amazon.com/Age-Deleveraging.

Today’s Outside the Box is a condensed version of Gary’s monthly INSIGHT newsletter, and in this one he tackles the lack of effectiveness of the Fed’s QE1 and QE2 and delves into the “strange things [that] happen in security, currency and commodity markets that don’t fit normal rules” when the Fed and other central banks take interest rates down close to zero. He notes that at the same time QE2 was fomenting a global commodity bubble and stock-market advances through 2010 and into early 2011, it was also punishing lower-income households with higher food and energy costs, and saddling them with falling home prices “that are likely to drop another 20%.” Crucially, the Fed is “pushing on a string” that, with “the depth and breadth of the financial crisis, the collapse in housing, the ongoing sovereign debt crisis in Europe, Japan’s continuing two-decade-old deflationary depression, the impending hard landing in China, etc. make the monetary policy string much more limp than usual.”

Picking up a theme from his most recent book, The Age of Deleveraging, Gary also examines the question of whether the US is headed for a deflationary depression like the one that has beset Japan for more than two decades. I won’t spill the beans on his conclusion here, but let’s just say that we have our work cut out for us.

If you appreciate Gary’s lucid analysis and want to subscribe to INSIGHT, be sure to mention Outside the Box, and you’ll get 13 issues for the price of 12, PLUS their January 2011 report in which Gary lays out his investment strategies for the year. The price via email is $275, and the address is insight@agaryshilling.com, or you can call them at 1-888-346-7444.

Your loving London but lusting for Ireland analyst,

John Mauldin, Editor
Outside the Box

Absolute Zero

(excerpted from the September 2011 edition of A. Gary Shilling's INSIGHT)

In its written release after its August 9 Federal Open Market Committee policy meeting, the Fed included a statement that was highly unusual because of its specificity. “The Committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid 2013.”

In the recent past, the Fed has stated its plans to keep rates low for an “extended period,” but we can’t recall the central bank ever being this precise on any policy. The statement was also significant because it means that unless the economy takes off like a scalded dog, the overnight federal funds rate will continue close to zero, its absolute bottom. Not surprisingly, longer term Treasury rates dropped on the announcement. The 2-year note yield fell to 0.185%, an all-time low, and the 10-year note yield hit 2.033%, below the previous 2.034% low reached on Dec. 18, 2008, after the collapse of Lehman Brothers drove investors to the safe haven of Treasurys.

Not Alone

The Fed is not alone in keeping central bank short-term rates close to zero (Chart 1) in response to sluggish and declining global economic growth and the inability of massive monetary and fiscal stimuli to revive economic activity. The outlier among major central banks is the ever-inflation wary European Central Bank, the spiritual descendant of the German Bundesbank and based in Frankfurt, Germany, for good reason. The ECB raised its target rate in April and again in July to 1.5% in response to Eurozone consumer inflation above its 2% annual rate target for the overall index. Nevertheless, ECB President Trichet apparently has put further increases on hold and may later cut its rate in response to unfolding weakness and persistent financial turmoil in Europe.

Zero interest rates are significant for several reasons. Zero is the floor below which rates normally don’t fall, although the 3-month Treasury bill rate recently was negative amidst investors’ mad rush for liquidity and the safe haven of government paper. More importantly, at zero interest rates, strange things happen in security, currency and commodity markets that don’t fit normal rules. This doesn’t mean that actions are illogical and don’t follow rational behavior, but rather that the rules of difference. Most observers don’t understand thoroughly the new norms, their causes and effects. Most significantly, central bankers and fiscal policy managers don’t seem to either, which makes forecasting the outcome of their actions and the unintended consequences extremely difficult.

How We Got Here

You’ll probably recall how the Fed got to its current federal funds target of 0-0.25%. In early 2007, the subprime residential mortgage market started to fall apart. By August, the Fed had cut its discount rate and the federal funds target rate shortly thereafter, initiating the declines that resulted in the current levels.

In 2008-2010, in what became known as QE1, the Fed bought $300 billion in Treasurys, $1.25 billion in residential mortgage- related securities and $100 billion in Fannie Mae and Freddie Mac securities in an attempt to further prop up the faltering housing market and reduce mortgage rates. But these efforts were of little aid to the housing market, and prices resumed their decline in mid-2010 after the effects of the tax credits for new home buyers expired. So, in August 2010, Fed Chairman Bernanke hinted at QE2, which was implemented in late 2010, ran through mid-2011 and initiated the purchase of a net additional $600 billion in Treasurys.

No Follow-On Effects

Like QE1, QE2 did put money in the hands of investors in return for Treasurys, but had no follow-on effects. As we’ve discussed repeatedly in past Insights, the Fed creates reserves by buying Treasurys and other securities. It doesn’t print money, as the media insists, except for paper currency to satisfy public demand. It requires the cooperation of the banks as lenders and the creditworthy borrowers to turn those reserves into loans and money. But banks and borrowers have been reluctant to do so and excess reserves over and above reserve requirements now total about $1.6 trillion. Nonfinancial businesses have more than ample cash and little desire to borrow. Creditworthy individuals are also reluctant to borrow, and instead are paying down their mortgage and other debts.

Mortgage Rates

With QE2, the Fed did not achieve its goal of reducing mortgage rates further to aid distressed homeowners. When Fed Chairman Bernanke hinted at QE2 last August, 30-year fixed rate mortgage rates did fall along with 10-year Treasury note yields to which they are linked, but then rose when the program was finally announced in November. Was this a classic case of buy the rumor, sell the news?

The central bank did, however, succeed in staving off the threat, or at least the fear, of deflation as QE2 fueled the already rapidly expanding commodity bubble. And it succeeded in stimulating stock prices. Apparently, investors reacted as usual to Fed ease by buying equities even though the usual and crucial intervening step—the creation of money through the lending of bank reserves to finance those purchases—has been missing. The same response no doubt hyped the commodity bubble, which also has been fed by expectations of China and other developing lands buying all the industrial and agricultural commodities in existence.

The leaps in stocks and commodities were reversed last spring, however. The 2010 sovereign debt crisis in Europe was re-run with increased intensity and, now, the feeling of hopelessness. U.S. consumer confidence has nosedived in response to Washington’s handling of the federal debt limit and fiscal restraint as well as persistent high unemployment. And the prospects of slower global growth if not recession threatens recent rapid growth in corporate profits (Chart 2).

Two-Tier Recovery

Furthermore, we doubt seriously that the Fed’s goal with QE2 was to aid just the folks on top while punishing the lower tier with the higher energy and food costs that flowed from the commodity bubble. But that’s what happened. Until very recently, Americans on the top have benefited from the two-year rally in stocks, commodities, foreign currencies and other investments that were slaughtered during the Great Recession. The rest of Americans are more affected by lingering high unemployment and by falling house prices that are likely to drop another 20%.

Pushing On A String

Despite their lack of effectiveness, QE1 and QE2 as well as earlier non-interest rate Fed policy actions were undertaken because conventional monetary policy, cutting the federal funds rate, was not doing the job. And for two distinct reasons.

First, as usual, the Fed was pushing on the proverbial string. Pulling the string, raising rates, works because borrowers are priced out of the market by rising interest costs. But lowering rates, pushing on the string, may not be effective if creditworthy borrowers, as at present, don’t want to borrow and banks, due to fear and regulations, don’t want to lend. Second, the depth and breadth of the financial crisis, the collapse in housing, the ongoing sovereign debt crisis in Europe, Japan’s continuing two-decade-old deflationary depression, the impending hard landing in China, etc. make the monetary policy string much more limp than usual.

No QE3

Many forecasters expected Chairman Bernanke to announce some sort of QE3 at August’s Jackson Hole conference, but were unclear what it would entail or how it would help. Would adding another $500 billion in excess reserves to the current $1.6 trillion do any more to induce lending and borrowing? In any event, at that conference, Bernanke proposed no new measures but said that the Fed still has “a range of tools that could be used.”

The Fed Chairman seems to be admitting that the Fed is out of bailout buckets with federal funds now at zero and quantitative easing anything but a raging success. It’s also true that except for bailouts of specific banks, monetary policy is very unspecific. Cutting interest rates may or may not encourage borrowing and investing, but it’s up to the lenders and creditworthy borrowers to decide where any loans get spent. QE2 temporarily helped the upper tier holders of stocks and commodities, but hurt the lower tier at which it probably was aimed by pushing up grocery and gasoline prices, as noted earlier. In contrast, fiscal policy measures can be quite precise. Helping the unemployed by extending jobless benefits does put money in their specific pockets.

Zero-Rate Problems

We’ll turn to the effects of zero interest rates outside the Fed shortly, but first note that it creates problems for the central bank itself, often with unknown

consequences. Reaching the zero federal funds rate forced the central bank into the quantitative easing business with unexpected and, on balance, poor results and meager effects. This and earlier non-interest rate actions also pushed the Fed uncomfortably close to fiscal policy, which put it in unknown territory and threatened its independence.

This zero federal funds target also led to the strange negative return on 1- month Treasury bills on August 4 during the stampede for liquidity. Investors were paying the Treasury to lend it their money (Chart 3)! Furthermore, a zero federal funds rate leaves the Fed no room to cut it when the next recession looms and the central bank want to provide some offset.

Some observers believe that the recent first time ever negative return on the 10-year Treasury Inflation-Protected Securities (TIPS) is so strange that it belongs in Ripley’s Believe It Or Not! Those folks neglect to mention that TIPS returns are adjusted for inflation. So if inflation over 10 years turns out to be 2% annually, a zero yielding 10-year TIPS will return 2% per year for that decade. Indeed, the spread in returns between TIPS and comparable maturity Treasurys measures market expectations for inflation. The current 2% difference for 10-year securities suggests that investors expect a 2% inflation rate because they are indifferent between the TIPS at 0% and the 10-year Treasury note at 2%.

Bond Bubble

Many observers believe that low, zero short-term rates have forced investors into longer-term Treasurys, which has pushed yields down and prices up (Chart 4), creating a bond bubble which is sure to break. Well, maybe, but we’ve been hearing similar "bond bubble" arguments since 1981 when 30-year Treasurys yielded 15.25% and we declared that “We’re entering the bond rally of a lifetime.” The rest, as they say, is history.

We persist in our conviction that 10-year Treasury coupon yields, which briefly fell below 2% in August, will continue to drop (Chart 5). We also continue to forecast a further drop in 30-year yields, now 3.6%, to 3% and perhaps even to the 2.6% reached at the end of 2008 amidst the Lehman collapse scare. One well-known bond manager sold off all his Treasurys early this year and then sold them short. He said that owners of government bonds were like frogs slowly being boiled alive and oblivious to the risks of owning Treasurys. As they say, the rest is history.

Bank Famine

U.S. banks are paying almost nothing for deposits, which continue to rise in a mad stampede for safety and liquidity. 2.5% Since December 2007, domestic deposits have leaped $1.1 trillion to $8.1 trillion. Indeed, Bank of New York Mellon last month began charging a fee for corporate cash deposits of over $50 billion, and others may be contemplating similar moves. The reason is that even cheap deposits—which on average pay 0.79%, with checking accounts close to zero—aren’t profitable to banks unless they can be lent at margins big enough to cover costs.

And that’s increasingly difficult as the yield curve flattens. One-month Treasury rates were essentially zero two years ago, as they are now, but in the meanwhile, rates for the longer term, in which banks normally lend or buy Treasurys, have fallen considerably. Of course, things aren’t as severe for bank spread lending as in early 2007 when the yield curve was inverted with short rates actually above long rates. The Fed had raised its federal funds target in the 2004-2006 era before it began slashing it in reaction to the financial crisis.

The squeeze on bank interest rate margins couldn’t come at a worse time for banks. With the sluggish economy, total loan demand has been subdued. That weakness is across the board, including commercial and industrial loans to business and consumer credit card borrowing. And with another recession in prospect, loan demand is destined to fall considerably.

Leveraged Up

Bank yields on assets are in a distinctly downward trend, which will no doubt persist as the Fed continues to keep short rates at zero for two more years and as the likely recession unfolds. No wonder that all of the six largest U.S. bank stocks recently traded at less than their net worth.

U.S. banks also have considerable exposure to the sovereign dent troubles in Europe. Of their global total exposure, 26% is in the Eurozone and it’s 45% if the U.K. is included. European banks are in worse danger due to their heavy ownership of the sovereign debt of troubled Eurozone countries. And their stocks were dumped by shareholders last month. Of course, the Standard & Poor’s downgrade of U.S. Treasurys didn’t help American and foreign banks that hold huge quantities of U.S. government securities.

Treasury Downgrade

The essentially zero federal funds rate measures the Fed’s reaction to persistent economic weakness and financial woes here and abroad. These same realities resulted in the seemingly diametric reaction in Treasury bonds when S&P cut its rating on government obligations after trading ended on August 5. This long-anticipated announcement was expected by many (but not us) to result in a collapse in bond prices as Americans and foreigners abandoned tarnished Treasurys. After all, S&P was reacting to the nonstop leap in federal deficits and debt and Washington’s weak response during the debt limit debate charades.

Instead, when trading opened on Monday, August 8, Treasurys continued the leap that commenced at the beginning of the month. And that day, 1-month and 3-month Treasury bills yielded a mere 0.02%. Why? The downgrades enhanced the global rush for safety and liquidity that had started in late July in reaction to the European sovereign debt crisis and slowing global economic growth with necesary overtones. On August 8, the Dow Jones Industrial Average fell 5.5%, the biggest drop since December 2008. Amazingly, all 30 Dow stocks fell and all 500 stocks in the S&P 500 Index suffered losses. Furthermore, corporate bonds and commodities were dumped. Falling confidence in Europe turned joy over ECB plans to support Spanish and Italian bonds to dismay over a possible downgrade of France’s triple-A credit rating.

Follow-on downgrades of government-controlled Fannie Mae and Freddie Mac as well as five triple-A insurers that tend to have sizable Treasury holdings also enhanced the stampede to Treasurys and other safe havens. The $2.9 billion loss for Fannie on home mortgages in the second quarter and posted August 5, up from $1.2 billion a year earlier, and its request for $2.8 billion more in government bailout money didn't help either. Also downgraded were 73 bond funds, ETFs and hedge funds with 50% or more direct and indirect exposures to Treasurys and government agency securities. We continue to have big 30-year Treasury bond holdings in portfolios we manage, but fortunately aren't rated so we couldn't be downgraded. Ten of the 12 Federal Home Loan Banks also had their credit ratings cut by S&P as were the ratings on 11,000 municipal issuers—to keep them in line with the lower Treasury rating.

Without doubt, there is a huge global crisis of confidence at present. It essentially results from the realization that governments, through their monetary and fiscal policies, have no magic bullets they can fire to return the economy to the 1980s-1990s salad days of rapid growth and soaring stocks. This is The Age of Deleveraging, and all the government efforts to date pale in relation to the deleveraging in the private sector.

Since early 2006, U.S. federal plus state and local debt has jumped from around 3% of GDP to 9.6% in the first quarter, or about a seven percentage point rise. But during the same time, the private sector delivered from about 16% borrowing-to-GDP to -0.5%, a 16 percentage point drop. So all the government deficits that lay behind that borrowing and the fiscal stimulus they represent offset less than half the deleveraging of the private sector.

Negative Effects

A key reason why monetary and fiscal policymakers are out of ammo is because of the questionable effects of earlier efforts. Quantitative easing by the Fed piled up $1.6 trillion in excess bank reserves that lie idle while pushing up grocery and gasoline prices for lower-tier consumers, the very people the Fed aimed to help. Fiscal stimuli added over $1 trillion to federal deficits and debt, spawning such a public and political outcry that further massive programs are off Washington’s table.

In Europe, it’s becoming clear that the Eurozone either breaks up or moves toward more unity and more bailouts. We’ve believed since the euro was established in 1999 that the basic flaw was combining the Teutonic North with the Club Med South under a common currency with no central fiscal control or prospect of it in such diverse lands. The current hope is to create a Eurobond to finance sovereign debts for which the Eurozone as a whole will be responsible.

But that would require central control over national tax and spending policies, a difficult change to sell to profligate countries like Greece and Portugal. It also means that the strong countries, led by reluctant Germany, would continually subsidize the Club Med set. At present, the Eurozone fiscal deficit as a whole is about 4.4% of GDP, not that bad since it’s held down by the Teutonic North’s fiscal discipline, and debt-to-GDP is around 87%, far from the number for Greece and Ireland.

So the Eurozone as a whole would be a strong borrower. But how much more debt could be piled on the underlying backs of Germany, the Netherlands, Finland and other strong economies before Eurobonds become junk? Furthermore, eurozone economies are slipping toward recession, as evidenced by the nosedives in consumer and business confidence.

Government Deleveraging

The reality is that governments, which escalated their monetary and fiscal leverage to bail out financial markets and other private sectors, are now being forced to join those private economic units in deleveraging. Attempts to hold back the tide, such as the limits on selling stocks short in France, Italy, Spain and Belgium, are ineffective attempts to blame market weakness on rumor-mongers and unscrupulous traders.

This is not to say that all the earlier monetary and fiscal stimuli here and abroad was in vain, even though it didn’t offset the massive private sector deleveraging and return economies and finance markets to robust health. The basic data shows that from the beginning of the recession in December 2007 through July 2011, disposable (after-tax) personal income rose $960 billion, $705 billion from increases in government transfers and tax reductions. From the $960 billion, 31% was saved, much more than the current average saving rate of 5%, but 78% was spent.

Dash To Cash

With the global crisis of confidence has come a universal lust for liquidity, especially cash. In the week ending August 1, the M2 money supply, which includes currency in circulation, bank deposits and retail money market funds, leaped $159 billion, or 1.7%, the third biggest jump since 1980. In perspective, the biggest was 3.2% right after 9/11 and the second, the 2.3% gain in the week of September 2, 2008 when Lehman collapsed (Chart 6).

In Europe, bank deposits at the ECB hit a 2011 high of €145 billion in early August even though that central bank pays a lower interest rate than interbank markets. And many banks probably will need the money later. The July “stress tests” were widely viewed as too easy to pass, as reinforced by an unusual move recently by the International Accounting Standards Board. It said that some European banks are using their own models to value Greek debt rather than the required market prices to determine the securities’ fair value. The “mark to model” rather than “mark to market” approach vastly overvalues the troubled Greek government debt they hold that has collapsed in value. Yields on 2-year Greek government debt hit a record of 43% in late August. Similarly, drops in the value of Spanish and Italian government bonds have impaired the balance sheets of their banks which hold large quantities of those sovereigns.

In July, the Committee on the Global Economic System, a central bank oversight group, said that an increase in “sovereign risk adversely affects banks’ funding costs through several channels, due to the pervasive role of government debt in the financial system.” The declining value of government debt, the panel went on, could weaken bank balance sheets and make bank funding more difficult. Indeed, European banks have been scrounging for U.S. dollars to add to their already-large liquidity hordes as U.S. money markets and other traditional sources became reluctant to lend to them.

Stressed Greek Banks

Meanwhile, Greek banks are stressed by massive withdrawal of deposits that move to safe-deposit boxes and under mattresses. One unlucky saver stashed cash in a brick wall but rats ate it. Deposits in Greek banks by households and businesses peaked at €238 billion in September 2009, but plummeted to €188 billion this June. About half of these withdrawals have fled the country, the central bank estimates, as chronic tax evaders fear a crackdown.

The Greek bank withdrawals have led to a bank liquidity shortage and increased reliance in the ECB for funding, and also to bank lending cuts and a further deepening in the Greek recession. The government now estimates a 5% drop in GDP this year compared to the 3.8% decline forecast on July 1.

Furthermore, Greek banks have heavy exposure to Greek government bonds, now rated junk, so they're frozen out of the interbank lending market. Piraeus Bank recently announced a €1 billion writedown of its bond holdings. It's also borrowing from a special central bank fund used to cover cash needs, the second Greek bank to do so, since its collateral is too weak to back ECB loans. The Piraeus writedown was part of the second Greek bailout deal reached in July.

The ongoing banking crisis no doubt was key to the recent decision of EFG Eurobank Ergasias and Alpha Bank, Greece’s second and third largest banks, respectively, to merge into the nation’s largest. This strikes us as two drunks leaning on each other in an attempt to keep each other standing.

Junk

Another result of the zero interest rate world was the earlier investor rush to junk securities in their zeal for higher yields. That drove the spread between junk bonds and Treasurys from its 20 percentage point peak in December 2008 almost back to the previous low in June 2007, according to our friend, Prof. Ed Altman of NYU. In 2009, junk bonds’ appreciation and interest returns combined were 57.3% and a further 15.3% in 2010. As in earlier boom times, investor zeal made refinancing sub-investment-grade securities easy, so defaults in the first half of 2011, at 0.2%, were also near record lows. Refinancing money was so readily available that defaulting on junk securities took real skill.

But the August agonizing reappraisal of financial markets has hit junk hard. Retail investors, who poured $2.8 billion into junk mutual funds in July and $43.8 billion between March 2009 and February 2011, yanked out $4.6 billion in the first three weeks of August. That forced junk mutual funds to sell securities, resulting in a -5.1% total return in the same weeks.

The junk yield spread over Treasurys, using Barclays Capital High Yield Index, leaped to 7.66 percentage points last month— the highest since November 2009—from 5.87 points at the end of July. This spread level, in the past, is associated with recessions when slow growth and lack of junk security financing hypes default rates.

With this rapid reversal, it’s not surprising that the junk issuers raised only $1.2 billion in August, down 93% from July’s $18.2 billion and the lowest since the market dried up in December 2008.

REITs also benefited from investor zeal for yield in a low interest rate world. Also, investors earlier saw them as immune from Europe's debt crisis and benefiting from the expected revival in economic growth and employment and the resulting demand pick-up for commercial real estate. In the first half of 2011, the Dow Jones Equity All REIT Index was up 9.9% vs. 6% for the S&P 500. In the last two years, REITS returned about 30% annually.

As Insight readers know, however, we've been cautious on REITs except for those involved with rental apartments and medical office buildings, and felt their stocks got way too far ahead of themselves. Recently, they've fallen back along with stocks in general. Also, lending for commercial real estate-backed securities is drying up, curtailing REIT acquisitions and debt refinancing. And the looming recession will cut demand for office space, hotel rooms and warehouses.

Are Stocks Cheap?

Low and zero interest rates also influence investors’ views of the values of stocks. The theory says that lower interest reduces the discounting rate that converts future earnings into current stock values and thereby raises their present worth. Also, lower interest rates are supposed to raise price-earnings ratios by making stocks cheaper relative to bonds.

In any event, stock bulls and many equity analysts believe that corporate profits growth has been so robust that even considerable economic weakness will not depress stock prices significantly from current levels. And, as usual, equity analysts see robust company-by-company earnings for 2012, with a gain of 14.4% for this year’s estimate for S&P 500 operating earnings. More sober, top-down strategists still look for a rise of 5.9%. Those numbers put the S&P 500 currently selling at 10.3 and 11.4 times next year’s earnings, respectively—reasonably cheap relative to the 19.0 average P/E since 1960.

But only two quarters of 2011 earnings are recorded so far, and estimates for the second half may prove to be far too rosy, jeopardizing the bottom-up analysts’ forecast of a 17.8% gain for 2011 and 14.8% for the top-down strategists. Similarly, their forecasts for 2012 may prove unrealistically optimistic.

We’ve never understood the concept of P/Es that compare current prices with next year’s earnings forecast. It strikes us somehow as double- discounting, of forecasting future earnings and then treating those forecasts as certain enough to determine the current values of stocks. This approach works in long bull markets with steady earnings gains, but come a cropper when the bear visits.

Our friend, Yale Professor Robert Shiller, avoids this problem as well as the volatility of recent corporate earnings by calculating the S&P 500 P/E based on earnings over the last 10 years (Chart 7). His average since 1960 is 19.4, implying that stocks in July when his P/E was 22.9 were 18% overvalued. More important, in reaching that long-term average P/ E of 19.4, stocks spend about half the time above it and half below. Most of the last decade has been above the average line, so there may be some catching up on the down side. This fits our view of a decade or so of deleveraging and a secular bear market that started in 2000.

The U.S. and Japan

Interest rates close to zero and all the related issues are relatively new in the U.S. and Europe, but they’ve been around in Japan for two decades. So, many wonder if the U.S. is headed for Japan’s 20-years-and-running deflationary depression. And regardless, what does the Japanese experience tell us about living in this atmosphere?

There are a number of similarities that suggest that America is entering a comparable long period of economic malaise. The Age of Deleveraging forecasts a similar decade, at least quite a few years, of slow growth and deflation as financial leverage and other excesses of past decades are worked off. The recent downgrade of Treasurys by S&P parallels the first cut in Japanese government bond ratings in 1998, followed by S&P’s cut to AA-minus early this year and Moody’s reduction from Aa2 to Aa3 last month.

The recent slow growth in the U.S. economy—real GDP gains of 0.4% in the first quarter and 1.0% in the second—looks absolutely Japanese. Furthermore, the prospects of substantial fiscal restraint in the U.S. to curb the federal deficit is reminiscent of tightening actions in Japan in the mid-1990s. The economy was growing modestly, but deficit- and debt-wary policymakers in 1997 cut government spending and raised the national sales tax to 5%. Instant recession was the result.

Big government deficits in recent years are another similarly between these two countries and the U.S. net federal debt-to- GDP ratio is headed for the Japanese level. Japan’s gross government debt last year was 226% of GDP, far and away the largest ration of any G-7 country. All governments lend back and forth among official entities so their gross debt is bigger than the net debt held by non-government investors, and Japan does more of this than other developed lands. Still, on a net basis, her government debt-to-GDP is only rivaled by Italy’s and leaped from a mere 11.7% in 1991 to 120.7% in 2010. Is the U.S far behind (Chart 8)?

Japan, in reaction to chronic economic weakness, has spent gobs of money in recent years, much of it politically-motivated but economically questionable, like paving river beds in rural areas and building bridges to nowhere. Is that distinctly different than the U.S. 2009 $814 billion stimulus package that was supposed to finance shovel-ready infrastructure projects when, in reality, the shovels had not even been made yet?

A key reason for the 2009 and 2010 U.S. fiscal stimuli and continuing deficit spending in Japan is because aggressive conventional monetary ease did not revive either economy. Zero interest doesn’t help when banks don’t want to lend and creditworthy borrowers don’t want to borrow . Both central banks found themselves in classic liquidity traps, so both resorted to quantitative ease, without notable success.

But Differences, Too

There are, then, many similarities between financial and economic conditions in the U.S. and Japan. Nevertheless, there are considerable differences that make her experience in the last two decades questionable as a model for America in future years.

The Japanese are stoic by nature, always looking for the worst outcome while Americans are optimistic—not as optimistic as Brazilians, but still prone to look on the bright side. Otherwise, why would the Japanese voters stand for two decades of almost no economic growth? Japanese are comfortable with group decision-making while Americans revere individual initiative, something the Japanese disdain. The nail that sticks up will be pounded down, is a favorite expression there. Perhaps because of this, the government bureaucracy in Japan is much stronger than in the U.S. while elected officials have less control and room for initiative.

Despite little economic growth, Japanese enjoy high living standards. And the Japanese are an extremely homogenous and racially-pure population.In a related vein, immigration visas don't exist in Japan, so there’s nothing in Japan like the chronic shift of U.S. income to the top quintile. Nothing like the two-tier economic recovery that benefited top-tier stockholders in 2009-2010, but left the rest struggling with collapsing prices for their homes and high unemployment.

Export-Led

Japan in the post-World War II era has been an export-led economy. “Export or die,” is the watchword. The result of robust exports and weak imports linked to anemic domestic spending is her perennial current account surpluses, which, along with earlier high saving by households and now by businesses, allow her to finance her huge government deficits internally, with foreigners owning only 5%. As a result, her government bond yields are extremely low.

In contrast, the U.S. is a chronic importer with a chronic current account deficit. So foreigners have perennially bought Treasurys with the resulting dollars they earn, and they now own about 50% of them. And Treasury note and bond yields are much more controlled by global forces and higher as well than in Japan.. The U.S. is largely an open economy but Japan’s, except for her formidable export sector, is largely closed to the outside world.

Another big difference is the chronic strength in the yen and long-time weakness in the dollar, resulting in part from the difference between Japan’s chronic current account surplus and America’s chronic deficit. Even near-zero short-term rates and 10-year government bond yield of about 1% do not deter those who lust for the yen. Of course, in a zero interest rate world where interest returns have dropped close to traditionally low Japanese levels in the U.S. and elsewhere, Japan at present does not have much of a competitive disadvantage.

The yen’s strength has led to Japanese manufacturers moving much of their production to lower-cost areas, but deflation in Japan has offset some of the difference. Corrected for deflation and on a trade-weighted basis, including trading partners such as Switzerland with robust currencies, the yen has been relatively flat since the 1980s, according to a Bank of Japan analysis.

Nevertheless, the government has intervened in currency markets numerous times, most recently spending $13 billion in early August, to arrest the yen’s climb vs. the greenback. And, of course, a government intervening against its own currency can’t run out of ammunition since it can easily create more of its own currency to sell on the open market. Still, intervention success has been limited, short- lived and expensive. Even a determined government with unlimited ammo has not been able to overcome the gigantic global currency markets that trade trillions of dollars daily.

We conclude that the differences between the U.S. and Japan are too great to use the Japanese economic experience in the last two decades as a template for the U.S. in coming years. Still, as discussed in The Age of Deleveraging, we expect a similar lengthy period of slow growth and deflation as the economy delevers. In any event, can policymakers do much to forestall this outlook? We argue in The Age of Deleveraging and did so earlier in this report that they can’t any more than the Japanese have been able to generate robust economic growth.

Savers Mauled

As we’ve been discussing, near-zero interest rates have distorted the financial and economic scene by pushing many investors into risky investments in foreign lands, commodities, junk securities and other investments they may come to regret. But many remain in bank CDs and money market funds for safety despite almost nonexistent returns.

Money market 7-day interest returns in August were a trivial 0.03%, and they would have been negative in many cases if fund managers had not waived their fees. And this condition will likely persist. The federal funds rate target, which rules other short-term returns, has been in the 0 to 0.25% range for three years, and the Fed intends to keep it there for two more years, barring a burst of inflation or a big drop in unemployment.

Save More or Less?

Will Americans be discouraged by low returns and save less, or will they save more to reach lifetime goals? They'll do the latter, in our judgment, which is one more reason why we expect the saving rate to jump back to double digits. Others, which we’ve discussed many times, include distrust of volatile stocks, the shrinking house appreciation that was tapped earlier to fund oversized spending, the postwar babies’ desperate need to save for retirement and chronic high unemployment, which encourages saving for contingencies.

CBO Forecasts

In last month’s Insight article, “Debt Bomb?,” our analysis slowed how important interest rates are to interest paid on the federal debt, the resulting contribution to deficits and to the growth in the debt total. As we noted then, the average maturity on the public U.S. debt outstanding was only 4.75% in 2010, at the low end of the yield curve. Furthermore, long-term Treasurys’ share of the debt outstanding has shrunk in the last decade.

The nonpartisan Congressional Budget Office’s new projections, which incorporate the reductions in federal spending enacted in August but also assume that the Bush tax cuts will expire on schedule, result in deficits totaling $3.5 trillion over the next decade, down from the $7 trillion forecast in January. The CBO assumes that GDP growth basically catches up from the depressed rates of recent years, rising to 5.0% annual growth in 2015 before dropping back to 2.3% in 2020 and 2021.

In contrast, we see slower annual growth, 2.0%, throughout the decade. The unemployment rate is assumed by the CBO to drop back to 5.2%, again very optimistic in our judgment. Faster economic growth propels taxes and thereby restrains the deficit while also reducing the deficit-to-GDP and debt-to-GDP ratios by enlarging their denominators. Lower unemployment also eliminates the deficit-enhancing pressure to create more jobs that concerns us.

The CBO sees 3-month Treasury bill rates rising gradually to 4.0% over the next decade and 10-year Treasury note yields to 5.3%. Its net interest paid projections divided by the CBO's debt forecasts yield its effective interest rate for financing the debt, and it rises from 2.2% last year to 4.6% in 2021. As a result, net interest-to-GDP peaks at 2.8% in 2020, below the earlier peak of 3.2% reached 20 years ago. Even with the CBO’s assumptions that the effective interest rate on the federal debt jumps from 2.2% to 4.6%, interest costs-to-GDP does not skyrocket. With our projection of no rise in interest rates over the next decade, interest costs-to-GDP reaches only 2.4% in 2021 even if we assume that the debt held by the public rises $1 trillion per year for a decade and nominal GDP rises only 2% annually. Either way, relatively low interest rates in future years will help contain interest paid-to-GDP ratios for the federal government and, therefore, growth in the government deficits and debt.

Featured Video: Gary Shilling on Outlook for Global Economies

JohnMauldin — Sat, 03 Sep 2011 05:29:00 GMT

Watch exclusive video below of Dr. A. Gary Shilling, president of A. Gary Shilling & Co., giving his 2011 Outlook for Global Economies and Investment Strategies. This important presentation was filmed at the Strategic Investment Conference 2011 in La Jolla, CA.

Still Home Sick

JohnMauldin — Tue, 17 May 2011 02:14:00 GMT

Everyone is curious about the state of housing in the US. My friend Gary Shilling recently did a lengthy issue on housing as it is today. I asked him to give us a shorter version for Outside the Box, and he graciously did. And you want to know what Gary thinks, because he is one of the guys who really got it right early, from subprime to the bubble and the price collapse, and has been right all along. No one is better. This very readable edition is full of charts and fast reasoning.

The quid pro quo for getting him to give us something that is normally behind a velvet rope is that I put a link in to let you subscribe to his wonderful monthly letter. He really is one of the better analysts out there. He has spoken at my conference the last two years and is one of our highest-rated speakers.

You can subscribe and mention the OTB and get 13 issues for the price of 12, plus Gary’s January 2011 report laying out his investment strategies for the year. $275 is the price via e-mail. Call them at 1-888-346-7444 or e-mail insight@agaryshilling.com .

And for those in the Dallas area, it is now my intention to meet some friends at the Zaza after the Tuesday night Mavericks-Thunder game, so drop on by.

Your living the internet-driven life analyst,

John Mauldin, Editor
Outside the Box

Still Home Sick

(Excerpted from the May 2011 edition of A. Gary Shilling's INSIGHT)

All may be well. That’s what many housing optimists proclaimed a year ago when prices appeared to have stabilized, indeed, started to recover from their collapse (Chart 1). As Insight readers are well aware, we emphatically disagreed. We pointed out that the earlier extremes in the housing market made rapid revival—or any revival for that matter—extremely difficult. In the earlier salad days, housing was propelled by low mortgage rates, lax or nonexistent underwriting standards, securitization of mortgages that passed seemingly creditworthy and highly-rated but really toxic assets on the unsuspecting buyers, laissez-faire regulation, and most of all, almost universal conviction that house prices never fall on a nationwide basis—which they hadn’t since the 1930s.

But housing activity remains at post- World War II lows (Chart 2).

The Administration's Home Affordable Modification Program (HAMP) was a bust. Tightening lending standards, the renewed decline in house prices, fears of job loss as unemployment remains high and the drying up of mortgage securitization have handily offset the positive effects of low mortgage rates and new homeowner tax credits. Indeed, the jumps in home sales in anticipation of the tax credit expiration first in November 2009 and then in April 2010 were promptly retraced and followed by still-weaker sales (Chart 3).

Mortal Enemy

Most of all, in making the case for continuing housing weakness, we’ve continually hammered home the ongoing negative effect of excess inventories on house sales, prices, new construction and just about every other aspect of residential real estate. In housing, as in every goods-producing sector, excess inventories are the mortal enemy of prices. It’s that simple. Lower prices are needed to unload surplus inventory, but in turn lower prices bring forth more inventory from anxious sellers. And the anxiousness of house sellers and reluctance of buyers is enhanced by the realization that house prices can fall, and are falling for the first time in 70 years.

Just how big are excess house inventories and how long will it take to absorb them? As discussed in many past Insights, we measure excess house inventories by the excess over the earlier trendless norm of about 2.5 million (Chart 4). We consider 2.5 million to be the normal working level for total existing units and new single-family houses (new multi-family inventories are not reported). Notice that this flat pattern, except for the recent extreme volatility, matches the equal trendless patterns of housing starts and completions over time. Note also that total inventories jumped to 5 million as housing collapsed, and still equals 4 million, or 1.5 million over and above the norm.

Hidden House Inventory

But wait! There’s more! The Census Bureau, in its estimate of housing inventory, lists a category called “Held off the market for other reasons”— very descriptive! This category leaped by over 1 million between the first quarter of 2006 and the first quarter of this year. It includes unspecified numbers of houses that have been foreclosed but not yet sold and units that people want to sell—first or second homes—but have not listed due to current market conditions. Of course, if those in foreclosed houses and those who want to sell finally do so and move into other abodes, they’re still occupying housing units and total inventories don’t change. But if they’re unloading extra and vacant houses or doubling up with family and friends, additional excess inventories are created. Many are now beginning to give up hope of higher prices as they continue to fall and throwing their houses on the market for whatever they will bring.

How Long?

Our total estimate of 2 million to 2.5 million excess house inventories, then, may well rise with further foreclosures that will be spurred by falling prices. This surplus is already huge since in the long run the U.S. builds about 1.5 million houses per year (Chart 2). To forecast the length of time to work off this excess inventory, we need to project supply and demand for residential units. New conventional construction of single-family house and apartment units plus manufactured home shipments is running about 700 thousand at annual rates. There’s no reason to expect this rate to change in the next few years, given falling prices excess inventories and other constraining factors. About 300,000 of these units are offset each year by dilapidated houses that are torn down, houses converted to nonresidential purposes and other factors that remove them from the housing stock. So the net supply will probably continue to average about 400,000 annually.

On the demand side, house sales data, especially existing house sales reported by the National Association of Realtors, appear to be overstated. Well, what did you expect? Did you ever meet a residential realtor who isn’t wildly optimistic about house sales and prices? The NAR uses models to expand its actual survey to national total sales numbers. With the collapse in housing activity, many of the multi-listing services that trade group samples have consolidation so the sales of those remaining expanded because their area of coverage has grown. Since the NAR doesn't correct for this, the sales numbers are likely overstated. Also, the NAR doesn’t sample but estimates the share of sales by owners that don’t go through multi-listing services. That segment of the market collapsed with the housing bust but the NAR has not subsequently adjusted its estimates downward.

In contrast, CoreLogic measures sales by checking property transfer records at local court houses and reports that its data covers about 85% of all house sales. Its numbers are consistently lower than the NAR numbers (Chart 5). In 2010, NAR reported 4.9 million in sales, down 5.7% from 5.2 million in 2009. But CoreLogic recorded only 3.3 million in 2010, a drop of 10.8% from 3.7 million in 2009. So the NAR data may overstate home sales by a third.

If so, and if house inventory data reported by the NAR are correct, it will take much longer to unload excess inventories at current sales rates. In March, NAR reported inventories of existing houses would take 8.4 months to sell at the trade group’s reported sales rate. That’s down from 12.5 months in July of last year but still almost about twice the level of healthy markets. And if NAR sales data are overstated by a third, the month’s supply is still back in double digits.

Household Formation

Because of the NAR's likely overstatement of sales and for other reasons, we prefer to rely on household formation data gathered by the Census Bureau to forecast housing demand. Now, there’s a lot of misunderstanding about household formation numbers. Many assume that there is a one-to-one relationship between the growth in the population and the number of new households formed. With population growing around 1% per year, or by about 3 million, then with an average 2.77 people per household, 1.08 million new households will be formed, the reasoning goes. But the link between demographics and household formation is at best a very tenuous one, especially in a cyclical time frame.

In the 2001-2010 decade, household formation averaged 888.5 thousand per year. Since those years included boom and bust years, this average, about 900 thousand per year, seems like a reasonable, probably optimistic forecast for the years ahead, given the likely further fall in house prices, high unemployment and declining real incomes in the years ahead. So if demand is averaging 900 thousand per year while supply runs 400 thousand, about 500 thousand of the excess housing inventory will be absorbed per annum. Consequently, it will take four or five years to absorb the 2 million to 2.5 million housing units, over and above normal working inventory, that we believe exist at a minimum.

Prices Down Another 20%

Four or five years is plenty of time for the inventory overhang to depress prices another 20% as we’ve been forecasting. Prices, after reviving somewhat with the new homeowner tax credit, are now essentially back to their April 2009 lows (Chart 1). Another 20% drop would bring the total decline from the peak in April 2006 to 45% and take them back to their longrun flat trend (Chart 6). In that graph, median single-family house prices are corrected for two types of inflation. The first is general inflation affecting all goods and services. The second is the tendency over time of houses to get bigger and, therefore, intrinsically more expensive. As living standards rise, people want more bathroom, fancier kitchens, etc. in their homes. A further 20% price drop may be an optimistic forecast since declines tend to overshoot on the downside just as bubbles expand to the stratosphere.

Other forecasters are coming into agreement with our forecast, dire as it is. The Dallas Federal Reserve Bank states that a 23% decline is needed to return house prices to their long-run trend. Prof. Robert Shiller of Yale says there is a “substantial risk” of another 15% or 20% decline in house prices. The NAR’s March survey of members revealed that 42% of everoptimistic realtors expect home prices in their areas to fall in the next 12 months. Starting last year, Shiller’s firm, Macro Markets LLC, asked us and 110 other housing experts to forecast house prices over the next five years. Since that survey commenced, we have consistently forecast a 20% cumulative decline for 2011-2013, with an 11% drop this year. Last June, the average forecast was a 1.3% price rise this year, but the last survey in early March reported a 1.4% drop.

There are other reasons to expect house prices to fall sharply in coming quarters. Now that the moratoria while mortgage modifications were attempted and during the robo-signing flap are over, foreclosures are likely to resume in earnest. And, as noted earlier, lenders and servicers tend to dump foreclosed houses on the market for quick sales, regardless of prices. These fire-sale prices put more homeowners under water and lead to more foreclosures, but they do attract investors looking for cheap houses who often pay all cash.

Cash-Ins

Many underwater homeowners, of course, still are committed to service their financial obligations, or want to stay in their abodes. Some are even doing cash-in refinancing, the reverse of the cash-outs of yesteryear, and contributing money from other sources to reduce their mortgage balances. A total of $1.1 trillion was withdrawn in 2006 and 2007, and at the peak of the housing bubble in 2006, cash-outs ran $80 billion per quarter and accounted for 90% of refinancings. By the fourth quarter of 2010, however, cash-outs dropped to 16% of refinancings and cash-ins jumped to 33%.

Homeowner deleveraging through cash-ins reduces the vulnerability to further house price declines, but they also reduce the funds available for other investments and current spending. So, too, do the higher downpayments lenders are requiring on house purchases, which also freeze out many potential buyers and otherwise discourage home ownership. Regulators are proposing 20% downpayments for high-quality new mortgages underwritten by private lenders, and Wells Fargo, the country’s largest mortgage lender, has suggested 30%.

For these loans, borrowers will also need to maintain 75% loans-to-market value ratios, 75% for refinancings and 70% for cash-out refinancings. Borrowers can't have missed two consecutive payments on any consumer debt within two years. Mortgage-related debt payments can be no more than 28% of income and total debt service can't exceed 36% of income. And mortgage loans must be fully amortizing—no interest-only borrowing. According to CoreLogic, 46% of all mortgagors at the end of 2010 had less than 20% equity in their homes.

Mortgages that don’t meet these standards will be subject to 5% retention by the original lender if they are sold to others or securitized. In other words, regulators intend to end the days when subprime mortgages were packaged as securities by the original lender and sold with no further recourse. Buy them, securitize them, sell off the securitized tranches and forget them was the strategy.

In fact, median downpayments on conventional mortgages already were 22% last year in nine major U.S. cities, according to an analysis by Zillow.com, up from 4% in the fourth quarter of 2006. Those cities are Chicago, Stockton, Calif., Las Vegas, Los Angeles, Miami-Fort Lauderdale, Phoenix, San Diego, San Francisco and Tampa. To be sure, private lenders are now making very few mortgages, with most initiated by Government-Sponsored Enterprises (Chart 7). The Federal Housing Administration, which required only 3.5% up front, accounted for 23.4% of residential mortgages last year. In contrast, in 1950, the median downpayment for FHA first mortgages was 35%, for Veterans Administration first mortgages, 8%, and 35% for non-government conventional first mortgages. Underwriting standards have tightened, but are still loose by those earlier standards.

The elimination of home equity for most mortgages will no doubt have severe detrimental effects on consumer sentiment and spending. It also will magnify the mortgage delinquencies and defaults, and severely depress the value of existing mortgages and derivatives backed by them In recent quarters, banks have booked profits as they reduced their reserves against potential loan losses, but that process will be dramatically reversed. And it goes without saying that mortgage lenders and servicers will severely tighten their mortgage underwriting standards with a further 20% drop in house prices. The top 10 mortgage servicers account for the majority of the market and include the nation’s largest banks.

Needless to say, another big decline in house prices almost guarantees another recession because of its financial impact. At the same time, further declines in residential construction won't matter much to the overall economy. It was 6.3% of GDP at its peak in the fourth quarter of 2005, but plummeted to a mere 2.2% in the first quarter of this year.

No Help to the Economy

Conversely, we don't look for any revival of homebuilding in the years ahead that will boost the economy. The housing collapse prevented residential construction from serving its usual role in spurring economic recovery from the recession. Rather than contribute meaningfully, residential construction actually declined in the first seven quarters of recovery. The ongoing housing crisis will probably continue to trouble financial markets, depress consumer spending and keep residential construction depressed for years.

Keep ‘Em Out – Or In?

From a regulator standpoint, tighter controls will continue to discourage homeownership. The Dodd-Frank financial overhaul law requires banks to retain 5% of the credit risks on lower-quality residential mortgages that are securitized and sold to others. These new rules will obviously discourage mortgage loans to all but the most creditworthy borrowers. Also, since Fannie Mae and Freddie Mac are backed by the U.S. government, they are exempt from the retention rules, which therefore will drive mortgage loans to these Government-Sponsored Enterprises. Still, their fates are uncertain.

Government attitudes toward homeownership also appear to have shifted with the housing collapse. On Oct. 15, 2002, when the housing boom was inflating, President George W. Bush said at the White House Conference on Increasing Minority Homeownership, “We want everybody in America to own their own home. That’s what we want…An ownership society is a compassionate society.”

In contrast, in February 2011, the white paper released by the Treasury Department and Department of Housing and Urban Development, which addressed the future of Fannie and Freddie, also stated that homeownership isn’t for every American. “The Administration believes that we must continue to take the necessary steps to ensure that Americans have access to an adequate range of affordable housing options. This does not mean, however, that our goal is for all Americans to become homeowners. Instead, we should make sure that all Americans who have the credit history, financial capacity, and desire to own a home have the opportunity to take that step. At the same time, we should ensure that there are a range of affordable options for the 100 million Americans who rent, whether they do so by choice or necessity.”

“Become Renters Again”

The statement echoes the muchmaligned comments by then-Treasury Secretary Henry Paulson of the Bush Administration in the midst of the housing collapse. He said in a December 2007 online Q&A session: “And let me be clear—we will not avoid all foreclosures. Borrowers who are struggling even with the lower initial ARM rate are unlikely to be eligible for assistance, and likely will become renters again.”

Furthermore, Congressional Republicans are proposing the end of tax deductibility of mortgage interest, which would further reduce the appeal of owning abodes. This is the largest of the “tax expenditures” and will cost the federal government $600 billion from 2009 to 2013, according to the Congressional Joint Committee on Taxation. Whether this tax break aids homeowners is questionable, however. In the European Union, where mortgage interest is not tax deductible, the homeownership rate is 75% compared with the earlier U.S. peak of 69%. Furthermore, lack of mortgage interest deductibility may encourage homeowners to pay off their loans faster, and avoid that false assumption that owning an abode is cheaper than renting.

At the same time, homeownership continues to be very political powerful, and many recent government actions can certainly be viewed as an unstated attempt to keep people in their homes, even those who clearly can't afford to own them. The reality that many foreclosures have tossed homeowners out is powerful not only to those affected directly, but also to many others in and out of Washington. Our friend and superb housing analyst Tom Lawler has taken a hard look at the numbers and worked his way through the many assumptions needed to determine the number of homeowners who lost their homes to foreclosure last year. He concludes it was about 1 million. Tom goes on to point out that many others have really lost their homes but not technically since foreclosures are not yet completed. These "owners" may still be living in those houses— rent-free, by the way!

There’s also sympathy for the many who, despite concerted efforts, have been unable to reduce their mortgage and other debts such as auto, student and credit card loans. Their total debt in relation to disposable personal income (after-tax income) peaked in the third quarter of 2007 at 131%. Debt itself peaked three quarters later in the second quarter of 2008. From then through the fourth quarter of 2010, mortgage debt dropped $517.9 billion and consumer (other) debt has fallen $174.6 billion for a total decline of $691.5 billion.

No Debt Repayment

But in those same 10 quarters, $542.2 billion in mortgage debt was charged off and $333.8 billion in consumer debt for an $875.9 billion total. As shown in the last three columns, after accounting for charge-offs, mortgage debt actually rose a bit, $24.2 billion to $10 trillion, consumer debt climbed $159.2 billion to $2.4 trillion and the total rose $183.4 billion to $12.4 trillion. The rise in mortgage debt ex charge-offs is so small that it’s merely a rounding error, but it’s surprising that it didn’t fall significantly. Perhaps financially stressed homeowners who didn’t lose their homes to foreclosure have not been able to reduce their mortgage debt.

To encourage home-buying, Washington enacted tax credits for new homeowners, which initially expired in November 2009 and then was renewed until April 2010. HAMP’s goal is to stave off foreclosures for underwater homeowners by making their mortgage payments more affordable. The government essentially told major mortgage lenders and servicers to forestall foreclosures while HAMP modifications were being attempted. More recently, 14 large financial institutions have been ordered by regulators to revise their mortgage servicing practices to encourage more successful modifications and speed up foreclosures. Those 14 have until mid-June to establish their plans and then 60 days to implement them.

Among other things, the mortgage servicers will be required to have a single point of contact for borrowers to avoid their being bounced from one servicer employee to another and getting lost in the shuffle. They also must set “appropriate deadlines” for deciding whether borrowers can qualify for a loan workout, and have enough staff to deal with the multitude of troubled mortgages. The goal is to get servicers to contact borrowers earlier and more frequently after one missed payment in order to have a better chance of modifying troubled loans.

Fannie and Freddie

The U.S. Treasury-HUD white paper cited earlier indicates that the Administration, like many other Democrats as well as Republicans, wants a significantly smaller role for government in housing finance, including a “winding down” of Fannie and Freddie and a smaller role for the FHA. House Republicans want Fannie and Freddie eliminated and only the FHA left as a source of federal backing. Currently, federal agencies including Fannie and Freddie guarantee 87% of new mortgages.

As discussed in our new book, The Age of Deleveraging, back in mid-2008, many FDIC-insured institutions were heavily leveraged but still had an average capital-to-asset ratio of 7.9%. In contrast, Freddie and Fannie had less than 2%, so for each buck of capital, they owned or guaranteed $50 in mortgages. Lobbyists from the two convinced Congress that they didn’t need more capital since defaults would be tiny as house prices rose forever. But when the housing sector nosedived, Fannie and Freddie’s houses of cards fell apart. So in September 2008, both were seized by the government in a legal structure called conservatorship. They are regulated, indeed controlled, by the Federal Housing Finance Agency. Initially, each had up to $200 billion backing from the Treasury, but it later was made open-ended through 2012.

Washington regarded Freddie and Fannie as part of the government. Assistant Treasury Secretary Michael Barr said that because they are “owned by the taxpayers in the biggest housing crisis in 80 years, it is logical that they be used to stabilize the housing market.” But since the two technically remain private corporations, their finances remain off the federal budget and their huge prospective losses from sour mortgages don’t need to be counted in the federal deficit. It’s ironic that the government is using Fannie and Freddie as the biggest off-balance-sheet financing vehicles in the economy at the same time it blasted banks for using off-balance-sheet entities in earlier years.

Also, by using these GSEs to support housing, with an open credit line to the Treasury, the Administration doesn’t have to approach Congress for funding bit by bit. The Treasury simply injects enough money, quarter by quarter, to cover their losses. As of Feb. 25, 2011, that was $153 billion for the pair, and the Congressional Budget Office estimates the losses through 2020 at almost $400 billion. Treasury Secretary Timothy Geithner in March 2010 said, “There is a quite strong economic case, quite strong public policy case for preserving, designing some form of guarantee by the government to help facilitate a stable housing finance market,” even after Fannie and Freddie are restructured or unwound.

More Private Capital

Nevertheless, the February 2011 white paper advocated a number of short-term measures to attract private capital into the mortgage market—with higher costs for house financing and its detrimental effects on home ownership. These include allowing the maximum loan limits to fall to $625,000 from $729,750 as scheduled on October 1, increasing downpayments on Fannie and Freddie guaranteed loans to 10%, and increasing FHA insurance premiums, which subsequently was announced to rise by 0.25 percentage points on 30- and 15-year loans to 1.15% on low downpayment loans.

The Administration believes that given the fragile state of the housing sector, it will take at least five to seven years to move to a longer term structure of housing finance. It offered in the white paper—but did not discuss in detail—three options, which no doubt will be hotly debated going into the 2012 elections.

The first is a privatized system with Fannie and Freddie eliminated. Their $1.5 trillion combined mortgage portfolio, out of the $10 trillion mortgage market, is already set to fall 10% per year. Government financial support would be confined to FHA and VA loans, which accounted for 23% of mortgages last year, targeted to help narrow borrower groups. Private lenders would originate and securitize mortgages without government guarantees. Interestingly, small banks oppose this option because they believe it would concentrate the business in the hands of large lenders, much to their detriment.

The second option would create a mostly private mortgage market as well as FHA/VA involvement, with a government “backstop mechanism to insure access to credit during a housing crisis.” Option three involves a privatized market as well as FHA-VA participation. New, privately-owned companies would buy mortgages from lenders and securitize them. Those securities would be guaranteed by the government as long as they met standards. These new private entities would essentially replace Fannie and Freddie.

Regardless of how government legislation and regulation unfold, the nation’s zeal for homeownership may be weakening outside as well as inside Washington. Homeowners have learned the hard way that for the first time since 1930s, house prices nationwide can and do fall. Zeal for a sound home financing system involves measures that discourage homeownership. And the likely leap in the percentage of renters and falling portion who own their abodes will reduce the power of homeownership advocates.

More Renters

Homeownership is falling, as the earlier boom and quick route to riches in a loose-lending environment has been replaced with collapsing prices, tight underwriting requirements, more regulation and horror stories of huge homeowner equity losses. As homeownership slides, the flip side, the renter population grows. Of course, many former and current homeowners are really renters with an option on their house's price appreciation. They put little if anything down and planned to refinance with cash-out before their mortgage rates reset upward or, in some cases, even before they skipped enough monthly payments to be foreclosed.

Homeownership bulls, naturally, argue that owning a house has never been cheaper. In calculating this index, the NAR assumes that a family with median income buys a median-priced single-family house with 20% down and financed at the current 30-year fixed mortgage rate. The collapse in house prices and decline in mortgage rates in recent years have more than offset the weakness in median family income that, according to the NAR, dropped from $63,366 in 2008 to $61,313 in 2010.

Nevertheless, comparisons between the current attractiveness of buying a home and that in the 1990s and early 2000s is like comparing an octopus to an ant. Back then, incomes were growing; now they’re weak. Unemployment rates were lower; now they’re high. House prices were rising as they had been since the 1930s; now they’re falling and even the stabilization last year has given way to renewed declines. Financing a mortgage was easy with little or nothing down and spotty credit; now it takes 20% or more in downpayments and sterling credit scores. Back then, the prospects of huge house price declines and massive foreclosures weren’t even the subject of horror films; now they’re the real, everyday reality.

Rents Still Cheaper

Despite the collapse in house prices, they are still expensive relative to rentals, even as apartment rental rates rise and vacancies decline. Those rent rises are having an interesting effect on the CPI. In the total index, 32% is weighted for shelter including 5.9% for the rental of primary residences. But an additional 24.9% is “owners’ equivalent rent of residences.” The idea is that homeowners rent their abodes from themselves at market rental rates. Of course they don’t, but this creates an odd situation where house prices are falling, but owners’equivalent rent is rising.

This, in effect, overstates the recent rise in the CPI. Chart 8 shows the year-over-year change in the core CPI, which excludes the volatile food and energy components, and the core excluding the shelter component, which is dominated by owners’ equivalent rent. That component is 32.3% of the core index and total shelter is 41.5%.

Notice that without shelter, the year-over-year core index rose 0.8%, or 0.4 percentage points less than the 1.2% rise in the total core. Back in 2007 and early 2008 before housing collapsed, owners’ equivalent rent was rising considerably faster than other prices in the core index, as shown by the gap in Chart 8 and in Chart 9. The fall in rent rates in 2008-2009 pushed the year-over-year change in shelter costs into negative territory.

The price index for personal consumption expenditures, which we and the Fed prefer to the CPI, also uses homeowners' equivalent rent, but only weights it at 15% of the total index and 17.5% of the core. Partly as a result of this lower weighting, the core index in March rose 0.9% from a year earlier compared to 1.2% for the core CPI.

Homeownership Downtrend

The fall in the homeownership rate has been swift, but probably understated. The overall rate in the first quarter, 66.4%, was down from the 69.2% peak in the fourth quarter of 2009 and was the same as in the fourth quarter of 1998. But Tom Lawler wrote on April 27 that “if the Q1/2011 homeownership rate by age group were‘correct,’ but the age distribution of households had been the same last quarter as it was in 1998, then the homeownership rate last quarter would have been 65.1%, or 1.4 percentage points lower than in 1998!”

In any event, continuing the rate of fall since its peak will bring the total homeownership rate back to its earlier base level of 64% in the fourth quarter of 2016 from 66.4% in the first quarter of this year. That's a return to trend. And we are strong believers in reversion to trend. Continuing the average annual growth in households over the last decade of 888.5 thousand increases the total number of households by 5.1 million from the first quarter to the fourth quarter of 2016. This is enough to increase the number of new homeowners by 608 thousand even with the drop in the homeownership rate to 64%.

But it also means the addition of 4.5 million new renters, or 782.7 thousand at annual rates. That’s a lot, but we’re not alone in this forecast. Greenstreet Advisors believes that a drop to 65% homeownership in the next five years will produce 4.5 million new rental households. Some of those people will no doubt rent cheap single-family houses, but most will probably be in rental apartments. In the longer run, only about 300 thousand multi-family units have been produced per year, or less than half our projected increase in renters. Apartment construction may again boom after the absorption of current vacancies pushes rental rates up enough to justify new building.

Our Theme

As we hope you’re well aware, we’ve been advocates of rental apartments as an investment theme for some time. It’s one of our long-term “buy” themes in The Age of Deleveraging. We also listed it as an investment strategy for 2011 in our Jan. 2011 Insight. In addition to all the reasons covered in his report, we noted in our January issue that rental apartments will benefit from the separation that Americans are beginning to make between their abodes and their investments. The two used to be combined in owner-occupied houses back when owners believed house prices never fall. So they bought the biggest homes they could finance. The collapse in house prices has shown them otherwise. Further weakness in the prices of singlefamily houses and condos due to the depressing effects of excess inventories (Chart 4) will add fat to the fire.

Contrary to general belief, a single-family house, excluding the effects of increasing size and general inflation, has been a flat investment for over a century (Chart 6). It does provide a place to live, but that value is offset, at least in part, by maintenance, taxes, utilities, real estate commissions and other costs. Furthermore, even with the tax deductibility of mortgage interest, renting a single-family house or apartment is cheaper than home ownership, absent price appreciation. Our repeated analyses over the years have shown this to be true, and even more so in the period of deflation we foresee when nominal house prices will probably fall on average.

Over time, houses have sold for about 15 times rental income. But that’s in the post–World War II years when owners of rental properties expected inflation to enhance their 6.7% return—before the costs of income tax–deductible maintenance and property taxes. When we were young and house price appreciation was not expected in the aftermath of the 1930s, the norm for rentals was 10% of the house’s value. If we’re right about our outlook for slow economic growth and falling house prices, houses and apartments may sell for closer to 10 times rentals than 15 times, much less the 20 times rental income in the housing boom days.

The separation of abodes from investments should work to the advantage of rentals in future years. We’re not suggesting that Americans will give up on single-family owneroccupied housing. The idea of a singlefamily home of your own is just too deeply embedded in the American culture. But many who have no pride of home ownership and who would vastly prefer to yell for the “super” (New York-ese for the building superintendent) than to apply a wrench to a leaky pipe have bought houses and apartments in past decades only to participate in capital appreciation.

The Old And The Young

They’ll be more inclined in future years to occupy rental apartments. This might be especially true of empty-nesters who don’t like to mow their lawns and who decide to unload their suburban money pits—especially because these homes are no longer appreciating rapidly but rather falling in price. At the front end of the life cycle, young couples may decide that because houses are no longer a great investment, there’s no reason to strain their financial, physical, and emotional resources to buy big, expensive houses as soon as possible. So they’ll stay in rental apartments a bit longer and wait until their kids are of the age that a single-family house makes sense.

Reinforcing our earlier analysis of the future demand for rentals is the surprisingly small shift in housing patterns it will take to make a big difference in the demand for and construction of rental apartments. Today, there are 131 million housing units in the U.S., including vacancies, of which 42 million are rentals. If only 1% of the total 112 million households decided to move to rentals, the demand for apartments would increase by over one million, most of which would need to be newly built after current vacancies are absorbed. This is a big number compared to new apartment starts of about 300,000 on average in the past. Rental apartments will also appeal to the growing number of postwar babies as they retire, downsize, and want less responsibility and more leisure time.

Like other REITs, apartment REITs rose rapidly last year (Chart 10) and may have over-anticipated the performance of the underlying investments in coming quarters. Direct ownership and other forms of investment in rental apartments may be more rewarding in the near future.

Rental apartments are not without their problems for investors. Prices haven’t risen dramatically lately compared to office and industrial buildings, but capitalization rates are relatively low, indicating that prices are high. Also, multi-family mortgage delinquencies and foreclosures are a problem, especially for Fannie, which with Freddie bought apartment loans in 2007 and 2008 as private lenders withdrew. Their share of multi-family loan purchases jumped to 85% in 2009 from 29% two years earlier. They own or guarantee 40% of the $325 billion multi-family mortgage market. Nevertheless, rental apartments are likely to be an attractive investment area for years as the joys and profitability of homeownership continue to fade.

2011 Investment Strategies: 9 Buys, 9 Sells

JohnMauldin — Mon, 24 Jan 2011 23:51:00 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. In 2009 in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. Last year he gave us 16 which the large majority hit the mark. 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, where he gives us 18 investable strategies for 2011

If you are interested in subscribing to 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 2011 forecast with price targets, plus an extra issue with his 2012 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....

Oh, I can't resist. Remember that list of the differences between the payroll differences between private and federal employees I had in the last letter? Rob Arnott wrote and pointed out that the biggest differential was in the cost of public relations personnel. I guess the cost of high quality practitioners of "spin" is seen as a necessary expense for the government.

Your enjoying the irony analyst,

John Mauldin, Editor
Outside the Box

2011 Investment Strategies: 9 Buys, 9 Sells

(excerpted from the January 2011 edition of A. Gary Shilling's INSIGHT)

As in the past, our investment strategies for 2011 are driven by our forecasts for the economies and financial markets here and abroad. In our view, the overarching reality that will dominate 2011 and, indeed, the next decade or so is financial deleveraging, as spelled out in our new book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, which was published in November 2010 by John Wiley & Sons.

We look for slow U.S. economic growth of 2% or less this year. The post-recession inventory bounce is over. Consumers are probably more interested in saving and repaying debt than in spending. State and local government spending and payrolls are falling. Excess capacity will retard capital equipment spending while low rents curtail commercial real estate construction. Economic growth abroad is unlikely to kindle a major export boom. Housing is overburdened with excess inventories. QE2 will be no more effective than QE1 in spurring lending and economic growth, while net fiscal stimuli will decline $100 billion in 2011 compared with 2010.

With slow growth, only a moderate shock will initiate a recession. Candidates include the deepening Eurozone crisis, a hard landing in China, and the 20% further drop in house prices we expect over the next several years. That would push underwater mortgages to 40% and hype strategic defaults while severely damaging consumer spending and the economy. In this environment, here are our 18 investment strategies for 2011.

1. Buy Treasury Bonds. We’re deliberately listing this strategy first not because of nostalgia, although this strategy has worked for us for 29 years on balance, and has been our most profitable investment. Instead, it’s because we expect further substantial appreciation with 30-year Treasury bonds, and because so few other investors believe our forecast has any chance of being realized. Fundamentally, we favor Treasury bonds...

—Because we foresee slow economic growth at best in coming quarters and years
—Because the Fed is determined to further reduce interest rates
—Because deflation is looming
—Because long Treasury bonds are attractive to pension funds and life insurers that want to match their long-term liabilities
with similar maturity assets
—Because as the U.S. moves ever closer to the slow growth and deflation of Japan, the parallel trends in government bond
yields seem likely to persist
—Because Treasurys are the safe haven in a sea of trouble in the Eurozone and elsewhere
—Because China’s attempts to cool her economy will probably precipitate a hard landing
—Because the likely price appreciation in Treasurys is in stark contrast to expensive stocks and overblown and vulnerable
commodities, foreign currencies, junk securities and emerging market stocks and bonds. We continue to predict that 30-year Treasurys, “the Long Bond,” will rally from its current yield of about 4.4% to 3% with appreciation of around 2.6%. Similarly, a 30-year zero-coupon Treasury would gain 48%. We also expect the 10-year Treasury note yield to drop from the present 3.3% level to 2.0%. but the appreciation would be only 11%, largely because of its shorter maturity.

2. Buy Selected Income-Producing Securities. This includes the high-quality corporate bonds although their spreads vs. Treasurys narrowed to 1.7 percentage points in 2010 through November from 2.1 in 2009 and 6.3 in 2008. We also continue to favor stocks of utilities, consumer product companies, health care firms, and others that pay meaningful dividends that are safe and likely to rise. Master limited partnerships are also possibilities, but only if their underlying businesses are secure enough to continue significant income payouts. 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 is pressuring them to again pay attractive dividends, and regulators may soon allow them to do so.

Dividends Are Back

After a long hiatus, companies that pay substantial, predictable, and meaningful dividends may be coming back into style for two distinct reasons. First, in a post-Enron/Arthur Andersen world and after gigantic write-downs have made reported earnings for many companies questionable, a company paying meaningful dividends is, in essence, assuring investors that it is generating the real earnings and real cash flow needed to finance those dividend checks.

Furthermore, a significant dividend payer will almost certainly continue to be run in a prudent and stable manner. Dividend cuts forced by the down phases of volatile earnings patterns are not loved by investors, as was shown when many financial institutions slashed or eliminated their dividend in 2008. Second, dividends may provide the lion’s share of earnings for many companies in future years, as discussed in The Age of Deleveraging.

Another reason that dividend-paying stocks are likely to be popular in coming years is a change in attitude by institutional investors, especially endowments and pension funds. In 2008, virtually all of the 40 investment classes we identified fell. That included U.S. stocks, foreign stocks in developed countries, emerging market stocks and bonds, junk and even investment-grade bonds, commercial and residential real estate, commodities, and foreign currencies against the dollar. In fact, Treasurys, gold, and the dollar against foreign currencies except the yen were about the only things that rose in price in 2008—classic safe havens.

3. Buy Small Luxuries. Consumers, especially when they’re hard-pressed as many are now, tend to buy the very best of what they can afford, even if it’s within a low-priced category. We developed this investment theme of small luxuries years ago when we noticed this tendency in apartheid South Africa. Urban blacks there often carried the elegant, slim, and expensive umbrella typical of investment bankers in London. They couldn’t afford cars or even taxi fares, but they did achieve status and satisfaction with fine umbrellas.

We think manufacturers and retailers that can adapt to the demand for small luxuries will be winners in the current environment. Some are adopting the small luxury mode by offering essentially the same products at lower prices by cutting their manufacturing costs.

Another route to small luxury success is to continually introduce new and improved models that make their predecessors obsolete. Apple is the master at this strategy, and the iPhone made the cell phone in my jacket pocket utterly antediluvian and forced me to upgrade to an iPhone. When my wife saw it, she realized her two-year-old model was obsolete so I gave her a new iPhone for Christmas. Of course, the new iPad, which she also got for Christmas, positively reeks of small luxuriousness since it’s too big for your pocket and will be visible to all your envious friends. Last fall, some back-to-school spending was diverted to iPads and other electronic gadgets.

4. Buy the U.S. Dollar, especially against the euro. Dumping on the dollar has been the favorite sport of investors and the financial media for years. Then 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 federal funds target rate at zero to 0.25%, even lower than in Japan. This made the greenback the preferred funding currency for the carry trade in which it was borrowed and then sold for higher-yielding currencies, such as the Australian dollar or the Norwegian krona. The falling dollar against those currencies also enhanced the profitability of those trades.

Buck dumpers also emphasized the tremendous number of dollars being pumped out by the Fed and the Treasury in their attempt to revitalize the economy, and the Fed’s clearly stated commitment to keep short-term interest rates low for an extended period. Furthermore, the left-leaning Congress and administration didn’t help the dollar with their twin goals of increasing government regulation and control of the economy and redistributing income from the higher-income people to lower-income households. These anticapitalistic policies tend to discourage foreign investors and encourage Americans to invest abroad.

The Reserve Currency

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. But alternatives to the dollar as the world’s reserve currency don’t exist. British sterling had that role in the 19th century, but it disappeared along with the British Empire. Switzerland’s economy and franc are safe and sound, but too small for global scale. Japan doesn’t want the yen to be a global currency. Ditto for China with the Yuan, which remains tightly controlled. What’s left?

Our basic argument for the greenback isn’t that the U.S. is a shining example of fiscal prudence and monetary integrity, a global example of a high saving, high investment economy driven by productivity growth. Rather, it’s our conviction that the dollar is the best of a bad lot and, at least for the next decade or so, the only reserve currency in town. The continuing purchases of Treasurys and other dollar-denominated assets by the central banks of developing countries with big current account surpluses suggest that they agree with us. In the third quarter of 2010, they (not including China) increased their dollar holdings by $416 billion and dumped $17.7 billion worth of euros, according to IMF data

Furthermore, until early 2010, almost everyone was on the dump-the-dollar side of the boat, a situation similar to that early in 2008 that preceded the dollar’s jump which started in mid-year (Chart 1). 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

5. Buy Eurodollar Futures. As we discussed in our Jan. 2010 and Aug. 2010 Insights, 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. In the case of short-term credit instruments, it’s Eurodollars

Our interest is in Eurodollar futures contracts based on these deposits. 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 $500. 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$ London Interbank Offered Rate (LIBOR) the 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.

Successful

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 (Chart 2). 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. And they did.

More recently, we were convinced that a weak economy and continuing financial woes would keep the Fed from raising interest rates any time soon—in contrast to the market’s assumption that rate increases were imminent. So in the last several years, Eurodollar futures nine months to a year ahead have been selling at higher interest rates and lower prices than current levels. But with our forecast, we reasoned, prices would rise to current levels when those contracts expire. So far, that has given us excellent returns and we’ve been rolling expiring contracts into new ones that will expire about a year later.

6. Buy Selected Health Care Providers and Medical Office Buildings. Health care is a huge sector, accounting for 16% of GDP and growing rapidly. Two major features of the current system almost guarantee explosive growth. First, most Americans don’t pay directly for their health care, which is financed by employer-sponsored insurance or the government through Medicare and Medicaid. That plus the fact that it’s “my life” that’s involved means that, except for deductibles and co-pays, there’s no restraint on usage. Many participate in what we call “recreational medicine”—take a day off from work at full pay to visit a physician, at employer expense, because of a minor ailment. Second, in paying for service plans, medical providers have many incentives to perform extra procedures because more office visits enhance their incomes. Defensive medicine with more procedures is also encouraged to avoid litigation over mistakes.

In addition, the demand for medical services in the U.S. will mushroom over coming decades due to several factors:

• Aging Population. Those over 65 have three times as many office visits per year as people under 45, and the oldest of the 78 million postwar babies will reach 65 this year and the youngest in 2029. The government estimates that Medicare and Medicaid expenses will leap from 6.4% of GDP this year to 10.7% in 2029.
• Technological advances are driving patient demand for more medical services.
• 32 million more Americans will be covered by health insurance under the new health care law, an 11% net addition by 2019. The Administration estimates that national health care expenses will rise from $2,632 billion in 2010 to $4,717 billion by 2019, only $46 billion, or 1% higher, than without the new law. But history suggests that the government is underestimating the growth in health care outlays. In 1967, the year after Medicare commenced, the House Ways and Means Committee forecast its cost at $12 billion in 1990. It turned out to be $110 billion—nine times as much.
• More Jobs. Increased demand for medical services in the years ahead will create jobs, but not enough to absorb all the unemployed in an era of slow economic growth. So Washington may readily accept the creation of more health care jobs than anticipated by the new health care law, ranging from nursing home attendants to brain surgeons. And slow growth and high unemployment will, as usual, encourage the uninsured to join government health programs.
• Little Supply Increase. The new health care law does little to increase the supply of medical personnel and facilities, but booming demand will result in the rapid growth of both, with the latter largely financed by private investments.
• Cost control pressures from government and employers will work to the advantage of big, profitable hospital systems with large campuses and expanding satellite facilities. Renewed growth in cheaper out-patient surgical and other facilities will also be a result of emphasis on cost containment.
• Hospital-employed physicians will increasingly dominate as medical recordkeeping requirements, cost containment pressures from government and insurers, constraints on government reimbursements, expensive new technology, the lack of economies of scale and high practice management costs, and lower incomes relative to hospital-employed physicians weigh on small private practices. Hospitals will also be better able to establish Accountable Care Organizations, authorized by the new law, which allows medical providers to share in cost savings.
• Undocumented immigrants are excluded from health insurance under the new law, so the newly-covered urban poor and the facilities needed to serve them will be most economically efficient in the cities that have fewer undocumented immigrants.

Medical Office Buildings

We also favor investments in medical office buildings (MOBs) that these increases and shifts in demand will require, including related outpatient facilities such as ambulatory care facilities, surgery centers, ambulatory surgical centers, and outpatient cancer and wellness centers. MOB demand is forecast to expand 19% by 2019, 11% of it due to the new law and the rest from population growth. The 64 million square feet are required to meet the demand of the new law and compares with a 2010 build of 7 million square feet. MOBs are much less volatile than other commercial and residential real estate, as shown by more stable vacancy and cap rates. They will not be plagued in future years by persistent excess capacity, which hinders new construction, as is the case with residential real estate, malls and office buildings.

7. Buy Rental Apartments. Rental apartments will benefit from the separation that Americans are beginning to make between their abodes and their investments. The two used to be combined in owner-occupied houses back when owners believed house prices never fall. So they bought the biggest homes they could finance. The collapse in house prices has shown them otherwise. Further weakness in the prices of single-family houses and condos due to the depressing effects of excess inventories (Chart 3) will add fat to the fire. So, too, will further house price weakness even after excess inventories are eliminated due to general deflation. As shown in Chart 4, corrected for the size of houses and inflation/ deflation, single-family house prices have been flat for over a century.

It will take a surprisingly small shift in housing patterns to make a big difference in the demand for and construction of rental apartments. Today, there are 130 million housing units in the United States, of which 36 million are rented. If only 1% of total households decided to move to rentals, the demand for apartments would increase by over one million, most of which would need to be newly built, after current vacancies are absorbed. This is a big number compared to new apartment starts of 333,000 on average over the past 10 years. Rental apartments will also appeal to the growing number of postwar babies as they retire, downsize, and want less responsibility and more leisure time.

8. Buy Productivity Enhancers. In the ongoing slow economic growth, deflationary environment, increased profits through price and volume increases is difficult for many firms. So the current cost-cutting zeal will remain in place. Labor cost-cutting has been in vogue lately, but does have its limits. So anything—high tech, low tech, no tech—that helps customers reduce costs and promote productivity will be in demand.

Ironically, the same new technologies that will continue to increase oversupply and promote deflation—computers, semiconductors, the Internet, biotech, and telecom—will be in demand to help combat its effects by helping to cut costs. Furthermore, chronic deflation will be a shock to many companies accustomed to operating in inflation, but not to a number of new-tech firms. It isn’t a question of whether computer chip prices will fall in any given year, but only by how much.

A basic characteristic of new technology is that it is continually surpassed by newer technology. In deflation, buyers of consumer and capital goods hold off purchases in anticipation of lower prices, and in so doing, force prices lower as excess capacity mounts and undesired inventories pile up. But in areas of rapidly advancing technology, buyers can’t wait for lower prices on existing products because they will soon be obsolete. Bear in mind, however, that many big U.S.-based technology companies get major portions of their profits from overseas, and those earnings will be hurt by a chronically rising dollar. Also, their consumer-related business will be subdued by consumer retrenchment, especially if it involves major discretionary purchases.

Cost-cutting also can come from low-tech sources. Outsourcing of call centers as well as information technology (IT) is a case in point. Routine medical and legal work is now being done much more inexpensively in India than in the United States. Temporary help agencies may thrive as companies increasingly curb costs by using temps only at the time of day or season of the year they’re needed, and avoid paying high benefit costs.

9. Buy North American Energy. Investments related to North American energy sources should continue to do well. The rationale is simple. The United States is increasingly dependent not on imported energy, especially crude oil. Ditto for petroleum products which follows from local resistance to the construction of new refineries. Import growth over time, of course, has resulted not only from rising demand for oil but also from falling domestic production (Chart 5).

Furthermore, energy imports, especially of crude oil, are coming from a number of countries with military and political instability, including Russia, Iran, Nigeria, and Venezuela. And whether the United States imports oil directly from, say, Iran or not is immaterial. Crude oil is fungible, and supply disruptions in any country are instantly transmitted worldwide.

10. Sell Home Builders and Related Companies. Home building was a growth industry in the salad days of low mortgage rates, lax underwriting standards, securitization of mortgages that passed seemingly creditworthy but in reality toxic assets on to unsuspecting buyers, laissez-faire regulation, and, most of all, conviction that house prices never fall. Now all these conditions have reversed with lending standards tighter, on balance, in part because lenders are being forced to take back bad mortgages. Bank of America just paid Fannie Mae and Freddie Mac $3 billion to cover faulty mortgages it had sold to them and still faces $6 billion in repurchase requests from private mortgage investors.

Furthermore, the securitization of mortgages is essentially dead, with government agencies the only buyers; regulation is much more vigilant; and homeowners are aware that they can lose money, even all of the equity in their highly leveraged houses. Home ownership rates (Chart 6) are falling as those who earlier bought houses to get in on the speculative bonanza are foreclosed out of their abodes, while prospective homeowners wait for still-lower prices.

Conventional home building is likely to be depressed for years. Excess inventories, the residue from the earlier home building boom, have only been partially absorbed despite the collapse in housing starts. New inventory is added as many of the homeowners foreclosed out of their abodes go back to living with parents or with friends, and as owners of investment properties that are empty or rented at below carrying costs give up and dump their houses on the market.

11. If you plan to sell your house, second home or investment houses any time soon, do so yesterday. If we’re right and house prices have another 20% to fall over the next several years, this strategy is obvious. Sure, it’s tempting to believe that all real estate is local and the only three important factors are location, location, location. But as the decline so far has demonstrated, prices can and have fallen nationwide for the first time since the 1930s. Almost no place in the U.S. was exempt from the sell-off.

12. Sell Selected Big-Ticket Consumer Discretionary Equities. We look for weakness in this sector for several fundamental reasons. Consumers, we believe, are in the midst of a chronic saving spree that will take their saving rate, which fell from 12% in the early 1980s to 0.8% in April 2005 and last November stood at 5.3%, back well into double digits. After the wild volatility and stock losses over the past decade, individuals don’t trust their portfolios to put their kids through college and finance early retirement. House price declines have already wiped out the home equity many used to finance oversized spending with more price declines in store.

As they save more and spend less of their median $62,300 household income, overall consumer spending will suffer. In 2008, those age 65 to 74 spent 12.3% less than 10 years earlier in real terms. A recent survey found that only 38% believe they have enough money to retire and of the rest, the biggest number plan to fill the gap by saving more.

Chronically high unemployment is another incentive to save because of the income uncertainty it creates. And the reality that real median household income fell 4.8% between 2000 and 2009 is another wake-up call for saving more and spending less. The need for households to spend less and save more to work down debt, a process barely started, is clear as is the need to rebuild net worth (Chart 7). Furthermore, the high correlation between household debt and personal consumption suggests that the recent strength in spending will be reversed.

The 9% jump in personal bankruptcies in 2010 from 2009 to 1.53 million, the highest since the law was revised in 2005, says many have been overspending and need to retrench.

No wonder that low-end dollar stores continue to thrive, especially since the number of households with income under $35,000 has jumped by 1.8 million since 2007. They’re even attracting thrifty better-off consumers as are second-hand stores that did a thriving business before Christmas in “pre-owned” or “formerly loved” items. Net sales rose 13% in 2010 from 2009, the strongest in five years. Construction of overbuilt full-price malls has almost stopped, and builders are turning their attention to the discount malls favored by thrifty shoppers. And don’t forget that the recent leap in energy prices, with regular gasoline now distinctly over $3 per gallon, is nothing more than a tax on consumers that cuts their discretionary income.

13. Sell Consumer Lenders. These stocks bucked the bull market last year and essentially were flat over the course of 2010. We look for further relative and even absolute weakness this year. Since the end of 2008, revolving credit balances (mostly credit card) have fallen by $135 billion to $822 billion as consumers delever and issuers tighten lending standards. Eight million cut up their credit cards and millions more paid down their balance and used cash for purchases. Credit card and other consumer lenders had their heyday during the long consumer borrowing-and-spending spree.

Consumers were trained by the media, retailers, and even the government 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. What a revolting development when consumers retrenched and cut back on their use of credit cards! What a surprise it was when consumers suddenly went further and switched to a saving spree and began to pay down credit card and other debt (Charts 8 and 9)! What a shock when heavy layoffs, leaping unemployment, collapsing house prices, and inadequate consumer incomes spiked credit card delinquencies!

Developments in the past several years are virtually all negative for the credit card business now and will be for years to come. Horror stories abound of people with $20,000 annual incomes who managed to run up $50,000 in credit card debt and then became unemployed. A cottage industry to help these people deal with their financial woes exploded in size. Cash and debit cards are replacing credit cards as consumers realize they can’t trust themselves to restrain debt and need to 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-long consumer borrowing-and-spending binge to a long-run saving spree, the credit card business has moved from a growth industry to a laggard.

14. Sell Medium and Smaller Banks. Smaller bank stocks rose even more than large ones last year but may reverse that performance this year. Ironically, in the go-go days, many of them were unwilling to virtually abandon their underwriting standards to compete with nonbank residential mortgage lenders. So they lent to the commercial real estate market instead, often residential construction-related firms.

Due to bad commercial as well as direct residential real estate loans, smaller banks have been dropping like flies. In 2008, 322 banks with $633.7 billion in total assets failed ($2.0 billion per bank), in 2009, 140 banks with $169.7 billion failed ($1.2 billion per bank) and another 157 with $92.1 billion failed in 2010 ($0.6 billion per bank). So those that have failed have gotten progressively smaller. As of last September 30, the FDIC had 860 banks on its “problem list” with an average of $440 million in assets, so more small bank failures lie ahead. Furthermore, many of the 600 banks that still have TARP money are small, weak institutions that have little access to alternative capital. And most of the 98 banks that got TARP money and are troubled are small ones with bad commercial real estate loans.

The declines in loan charge-offs are slower at small than large banks and many of them continue to add to loan loss reserves while large banks reduce them. Of the nation’s 7,830 banks, 91% had assets under $100 million. Not surprisingly, small banks complain that bank examiners are overly conservative, especially in assessing their commercial real estate loans. Individually, they aren’t too big to fail, but collectively they are since smaller banks 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.

Commercial banks hold about $1.5 trillion in commercial and multifamily housing debt. They also have around $500 billion in land and construction loans that are especially toxic since raw land and unfinished buildings provide no revenue but incur outlays for taxes, completion of the structures, guarding against vandalism, etc.

From June 2007 through 2008, banks with less than $10 billion in assets bought more than $4 billion in private-label mortgage bonds that are not issued or guaranteed by government agencies. Many of them were downgraded to junk status as homeowner defaults surged. Some of those banks believe the bonds will eventually pay off, but regulators forced them to reserve extra capital against likely losses.

The Achilles heel for medium and small banks is their troubled commercial real estate loans. Many more are likely to fail as those loans mature in the next several years.

15. Sell Junk Securities. 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 2009, and yielded 44.3 percentage points over Treasurys in December 2008.

But the bailout of the big banks and easing of the financial crisis allayed investor fears, and junk spreads collapsed to levels lower than in many pre–financial crisis years. Institutional investors piled in, followed by individual investors, many of whom sought alternatives to low returns on bank deposits and money market funds and who also bought investment-grade corporate and municipal bonds.

So the spreads on junk bonds collapsed and in 2009, junk bonds returned 57% and low-quality leveraged loans returned 52%, much more than the 24% gain on the S&P 500 Index, despite the fact that 11% of junk issuers defaulted that year. Some 265 companies defaulted on bonds, double the 2008 tally and more than the previous high of 229 in 2001. In 2010, contrary to our expectation, junk bonds rose another 13% in price as the default rate dropped to 1.1%.

In any event, we believe this rally was way overdone. In addition, the slow economic- growth, deflationary scenario we project this year and beyond will be lethal for many junk bonds, both those issued as high-yield instruments by companies with shaky balance sheets and fallen angels that have been downgraded to junk status. Slow revenue and cash flow growth, to say nothing of deflation, will make it difficult if not impossible for a number of financially weak and weakening firms to service their bonds and other debts as the principals of those instruments rise in real terms.

16. Sell Developing Country Stocks and Bonds. Developing country stocks and bonds rose last year, but we doubt those gains will persist. Most of those countries depend on exports for growth, a major part of which were bought by U.S. consumers in earlier years. But American consumers, in our judgment, are in the midst of a chronic saving spree that will curtail our imports and, in turn, overseas economies’ exports and economic gains.

Notice the effects of American consumer retrenchment and global weakness on Chinese exports in recent years (Chart 10), which broke the strong uptrend as a share of GDP. Notice also the declining and low share going to consumption, a mere 34% in 2009. This is well below G-7 countries or even India with 56%. China and others want to develop domestic-led economies, but are years away from lowering their high and rising saving rates and making other changes needed to spur their domestic economies. With no meaningful equivalent of Social Security retirement benefits and Medicare, Chinese need to save for their retirement and medical care.

Further, in the case of China, the stop-go economic policy is in the stop phase after the massive $585 billion stimulus program of 2009. She is trying to curb the resulting property market bubble and inflation by raising reserve requirements and interest rate, limitations on bank lending, controls on real estate and other means. Give the crudeness of her economic policy tools and the part-controlled, part-market driven nature of her economy, we believe a hard landing this year will result and GDP growth will plummet to recessionary 6% or so levels. This will be the shot heard ‘round the world, especially by those who have the same shock and awe over China that they had for Japan in the late 1980s, right before her real estate and stock bubbles broke and she entered two decades of deflationary depression that still persists. It will also again end the decoupling myth that says developing countries can grow rapidly, independent of advanced lands to whom they export.

17. Sell Selected Commodities. We believe that a full-blown commodity bubble had developed. The recent shortages of hard rock miners for copper and other metals is one more signal of a top in the commodity boom. A hard landing in China may well be the pin that pricks that bubble. Not only has she been a gigantic importer of coal, iron ore, nonferrous metal, resins, crude oil and other industrial materials both for current production and for stockpiles, but psychologically China is considered the center of global industrial production.

Any hint of a hard landing there will no doubt drop the scales from speculators’ eyes and industrial commodity prices, including copper, will swoon. So, too, will the currencies of commodity producers such as Australia, New Zealand and Canada. And the strong dollar we’re predicting will work to depress commodity prices, especially the many globally-traded ones such as oil that are priced in dollars.

We’re recommending sales of selected commodities because agricultural producers are influenced by global demand but also by weather-driven supply. Forecasting economies is tough enough, so we’ll leave it to others to forecast the weather. Note, however, that in the past, ideal growing weather often follows the bad weather suffered lately, and bumper crops and surpluses often replace hand-wringing shortages in a crop year or two.

18. Sell Many Old Tech Capital Equipment Producers. Our eighth investment strategy for this year, Buy Productivity Enhancers, includes many new tech companies. Nevertheless, old tech outfits are in a different atmosphere, in our judgment. True, their stocks did well in 2010, rising from their recessionary ashes to climb about three times as much as the SP 500, contrary to our forecast. This year, we’re renewing our forecast of weakness. We expect a hard landing in China to end the boom abroad and once again assert the dependence of many of those countries on now-retrenching U.S. consumers.

In the U.S., many expect the atmosphere of higher profits and piles of corporate cash will unleash a bonanza in capital equipment spending, reversing the recent leveling and decline in growth rates. Our analysis suggests otherwise. When operating rates are low, as at present, producers don’t need more capacity and worry that revenues, prices, and profits won’t be adequate to justify even existing capacity. Besides the depressing effects of excess capacity, low-tech and old-tech companies suffer from other 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 labor forces are sometimes a problem. And many sell into saturated, slow growth markets.

The Morality of Chinese Growth

JohnMauldin — Sat, 02 Oct 2010 01:35:00 GMT

Oil at $125 a Barrel, Gasoline at $5
David Rosenberg and Capacity Utilization
Gary Shilling: Commercial Real Estate and Employment
The Morality of Chinese Growth
Another Birthday? What Happened to My Year?
Athens and the Barefoot Ranch

This week I am at a conference in Houston. I must confess that I don't attend many of the sessions at most conferences where I speak. But today, the guys at Streettalk Advisors have such a great lineup that I am there for every session. But it's Friday and I need to write. The solution? This week you get a "best of" letter. The best ideas I've heard and the best charts I've seen at this conference. Then we close with two short but very thoughtful essays from Charles Gave and Arthur Kroeber of GaveKal on "The Morality of Chinese Growth." Lots of charts and something to make you think. Should be a good letter.

Oil at $125 a Barrel, Gasoline at $5

John Hofmeister is the former president of Shell Oil and now CEO of the public-policy group Citizens for Affordable Energy. He paints a very stark (even bleak, as he gets further into the speech) picture of the future of energy production in the US unless we change our current policies. First, because of the aftereffects of the moratorium. It is his belief that the drilling moratorium will effectively still be in place until at least the middle of 2012. There won't even be new rules until the end of 2011, and then the lawsuits start.

Gulf oil production will be down by up to 1 million barrels a day. Imported oil is now 67% of oil usage but will go to 75% by 2012. He thinks crude oil will be up to $125 and gasoline between $4-$5 at the pump. And it will only get worse.

He describes the problem with the electricity from coal production. The average coal plant is 38 years old, with a planned-for life of 50 years. Our energy production capability is rapidly aging, and we are not updating it fast enough.

He argues that the fight between the right and the left has given us 37 years without a realistic energy policy, as policy gets driven by two-year political cycles but good energy planning takes decades. There are 13 government agencies that regulate the energy industry, with conflicting mandates that change very two years. There are 22 congressional committees that have some level of involvement and oversight of the energy industry.

The following table is from data provided by Triple Double Advisors LLC, an energy specialty investment firm in Houston, Texas. John White was sitting next to me and showed me this table, pointing out the poor performance in terms of investor returns from renewable energy sources and the larger returns from Master Limited Partnerships where investors are seeking yield. It seems the market is voting that it doesn't have much confidence in the renewable energy world. Hofmeister suggests that government subsidies for renewable energy will go away under the pressure to get the fiscal deficit under control. Maybe the market senses that. He says we need to create a 50-year plan for our energy policy that transcends the political cycle. (I am going to get this speech transcribed and will post it so you can read it. This guy talks sense.)

David Rosenberg and Capacity Utilization

I am a big fan of David Rosenberg (former chief economist at Merrill and now with Gluskin Sheff in Toronto), and have really enjoyed getting to know him the last few years. He is a fun guy, even if his data is not exactly bullish. It was hard to pull out the best of his charts for this letter, because he had so many.

The first chart shows that real final sales are the lowest, four quarters after the end of a recession, that they have ever been. Average growth is 4%, but we're up less than 1% in the current recovery. The second chart (side by side with the first, below) shows the contribution of various sectors to real GDP growth. You find that of the 3% average growth over the last four quarters, 1.8% was inventory rebuilding. His point (and one I have made as well) is that this is not sustainable. At some point rebuilding will no longer be as big a factor, as inventories will get closer to equilibrium. And the consumer does not look like he is going to ride to the rescue.

Rosie thinks we could slip into negative growth by the end of the year.

This next chart shows U-6 unemployment compared to manufacturing capacity utilization rates. Unemployment will have difficulty getting better as long as capacity utilization rates are at what is typically thought of as recession levels.

The next and last chart from Rosie is on housing, showing us the large number of vacant homes and the vacancy rate. Home values are not likely to rise nationwide (there will be some good local pockets) until the vacancy rates come down. Ditto for new home construction and the jobs from that sector. Gary Shilling (see next section) says he thinks home prices could drop another 20%.

Gary Shilling: Commercial Real Estate and Employment

The next two charts are from good friend Gary Shilling (selected out of about 50 he had). The first shows us that the commercial real estate price index is down almost 40% from its peak. Judging from the graph, it looks like the freefall may be over for now, assuming we do not get into another recession too soon. Is it any wonder that bank lending is down, since so much lending was in commercial real estate and CRE construction?

The last chart shows us the trend line for the relationship between employment growth and GDP. It turns out that you need at least 3% GDP growth to get meaningful employment growth. If growth is slowing down to less than 2%, it is going to be very difficult to really address the unemployment problems.

And now, let's turn to GaveKal and China.

The Morality of Chinese Growth

We (GaveKal) spend quite a bit of time trying to understand the drivers and fundamentals of Chinese growth. And while we have seen some recent signs of a policy-driven cyclical slowdown (see The Wen Jiabao Put and our latest Quarterly Strategy Chart Book), we remain very optimistic about the Mainland's structural potential. But up until know, we have not really touched on the more philosophical implications of the Chinese growth story. In that respect, a recent client comment triggered a couple responses we modestly believe could interest the broader readership.

Client Comment: GaveKal's writings on economics are unmistakably filled with fundamental beliefs regarding human potential, advancement, creativity and the pursuit of knowledge. And even if I did not know your backgrounds, these views appear decidedly French in nature: deeply held beliefs on the rights and dignity of man.

So how does a group of economists focused on the mind and the soul as well as the pocketbook reconcile the sociological challenges presented by modern China? It is undeniable that a country that pulls half a billion people out of subsistence farming in two decades is doing a lot for human decency, no matter how they accomplish it. So maybe I need to throw away my Western lenses when thinking about this. But I really wonder sometimes how you view the authoritarian qualities of 21st century China as it relates to treatment of political rivals, the autonomy of the courts, religious freedoms, control of all forms of media, etc. Should we bend with the breeze and accept that this is the new world?

Charles answers: As I have tried to highlight in a couple of recent documents (see The Way the World Works and Ricardo, Schumpeter & the Cost of Capital), I firmly believe that an overly powerful and extended government is very dangerous. Having said that, I also believe that a total absence of the State is even worse. And since you mention my intrinsic Gallicness, I will turn to the philosophers of the Enlightenment, who happened to often be French, and who showed quite conclusively that human freedom can be exercised in three areas:

1. Political freedom (voting the incompetents out, separation of powers)

2. Social freedom (freedom of worship, sending one's children to the school of one's choice, creating a union, etc.)

3. Economic freedom (the ability to create a business, hire or fire employees, etc., regulated by contract law between acting parties).

What the philosophers of the 18th century argued was that the Church had to move out of the political sphere, and the State out of the other two. In Hong Kong, which GaveKal calls home, we enjoy one of the freest societies in the World: we have total social freedom, total economic freedom but yet very little political freedom. Still, I believe this compares extremely well with what we have in France, where the church of Marxism has invaded the State and the educational system, destroying both, while the obese State has invaded the social and economic sphere, leaving entrepreneurs without oxygen. As Tocqueville expected, we have moved towards a strange and benign "molle dictature".

This brings us to China and your questions. Today, the Chinese government is prepared to increase the population's economic freedom (far from complete), as well as the social freedom (courts of justice gaining grounds on political cronies, some social rights). But as for political freedom - see you in 20 years. In essence, this is the same deal offered to Singaporeans 30 years ago by Lee Kwan Yew, who now effectively vote for Lee Kwan Yew & sons every time they get a chance!

As a result, and to use Hanna Arendt's terminology, China is gradually moving from a totalitarian state to an authoritarian state, with a technocratic bias (à la Singapore). To a certain extent, the Chinese government discharges some of its responsibilities pretty well, with some gaping and horrible holes. So while the immediate picture may look ugly, the movement is in the right direction.

Arthur Kroeber answers: Basically I think you need to clarify your questions. Are you surprised that China has been able to deliver high-speed growth while remaining an authoritarian state? If so, there is nothing odd about this. South Korea and Taiwan both achieved their highest sustained growth under brutal dictatorships; Japan achieved its first growth spurt (in the Meiji era) under a benign despotism and its second (post-war) under a one-party state. And of course, most of the modern Western democracies were not really democracies in any modern sense (only landowners could vote, women did not vote…) while they were industrializing. The idea that countries must be liberal democracies in order to achieve high-speed early-stage economic growth is a strange fantasy with no empirical support.

Or is the question that you are worried that China's path to success means that other countries will follow the same route? Again, the evidence at hand shows that each successful economy, like Tolstoy's unhappy family, is successful in its own way and that outside models are of limited use (see Dani Rodrik's One Economics, Many Recipes).

The China model could work in China because of a specific set of historical and institutional factors that are not replicable elsewhere.

These include a 1,500-year history of centralized bureaucratic rule, which set the template for the current governance system of bureaucratic authoritarianism; an almost equally long history of active commerce and preindustrial capitalism which set the template for private sector activity once the state decided to get out of the way; and the presence of Hong Kong, which meant that China could make full use of modern Western institutions (such as a reliable legal system, property rights, efficient services, etc) without having to go through the cumbersome decades-long political hassle of building these at home. (On this latter very important point see the opening chapter of Yasheng Huang's Capitalism with Chinese Characteristics).

Or is your concern that China has been able to have a dynamic economy while doing nothing to reform its political system, and will continue to be able to do so ad infinitum? Here the perception that China has made no political reform is specious. There is a gigantic difference between China in the 1970s and China today in terms of freedom of expression, breadth of political discourse, personal liberty and property rights.

Through the end of Mao's rule, China was a totalitarian dictatorship ruled by individual caprice, with generally disastrous results (30-40mn deaths in the 59-62 famine, 10s of millions more in the Cultural Revolution, etc.). Since then it has transformed itself into a bureaucratic authoritarian state with very imperfect but generally increasing accountability of government. This is a massive political transformation. (And Huang, cited above, makes the important point that this "directional liberalism" -- this confidence that things were getting durably better -- was very important in encouraging China's entrepreneurs to start work in the 1980s, despite the absence of what we would consider clear property rights).

If we judge China not by how far it has to go but by how far it has come, the change has been dramatic, and we can reasonably expect the political system to continue to evolve in the coming decades, though not necessarily in linear or predictable ways.

Or is your concern that we in the West somehow have to render moral judgment on China, which requires some calculus along the lines of X amount of economic progress is worth Y amount of political repression, so if repression = y-1 then China is "good" and if y+1 then China is "bad"? Here I will wax philosophical and distinguish myself from Charles somewhat. Unlike him (and strangely, since I am generally considered the house Communist), I am not a Marxist, as I strongly believe that it is a society's underlying political bargains that tend to shape economic activity, not the other way round.

As Isaiah Berlin pointed out, societies grapple with the problem that there are lots of good things - justice, wealth, individual liberty, social stability, security, equity - and we cannot maximize all of them at once. Trade-offs among these ultimate values must be made and that is what politics is about. Societies create a set of trade-offs by negotiation (and by the way democratic elections are not in themselves a mechanism for making these trade-offs; they are simply a mechanism for transmitting information to the agents who are negotiating the trade-offs; so it is a fallacy to presume as many do that only via democratic elections can a society achieve a "true" bargain) and the ultimate bargain configures the playing field on which economic actors operate.

Among the societies we describe as democratic capitalist there are vast differences in the bargains and hence in the nature of economic activity. America tolerates levels of instability, crime, inequality and pernicious religious zealotry that Europeans and Japanese consider absurd, but it gets in return a much more dynamic entrepreneurial system of wealth creation. Japanese willingly accept levels of social conformity that Westerners consider bizarre, but achieves a high level of social stability and tremendous success in economic areas (such as high precision manufacturing), where self-disciplined social cohesion is a plus.

China, like all societies, is working out its bargain. It is still very much a work in progress but the process is dynamic, not static.

We Americans have a strange utopian tendency to assume that among all possible social bargains there is one perfect bargain out there (probably ours) and that it is our job to judge how well other people are keeping on the path to that bargain, any straying from which necessitates perdition for them and gnashing of teeth for us. But maybe we should just stop worrying about it. China will become what it will become and hopefully whatever it becomes will produce good results both materially and spiritually for most Chinese. As long as our society continues to do the same for us, it does not much matter whether the two societies wind up looking a lot or a little like each other. Chacun son gout!

Another Birthday? What Happened to My Year?
Athens and the Barefoot Ranch

I turn 61 next Monday. All the kids are coming into town to celebrate with Dad. I am really looking forward to it. But I really have a hard time believing that it's time for yet another birthday. I am sure it was just last month we celebrated my 60th. Thankfully I don't feel like I am 61.

It has been a great year on both a personal and business level. Italy with the family was a highlight, and not just of the last year. We are going back to Tuscany next year. I am so grateful that my business is growing and that we are finding new opportunities. Thank you for your support this last year.

And yes, I am going to Athens next week. Athens, Texas, that is. There is a rather large ranch/lodge called the Barefoot Ranch near Athens, where Kyle Bass of Hayman Advisors has invited some 50 people to gather and discuss the markets and the world at large for three days. Fund managers, writers, politicians, historians, and a fairly wide variety of interesting people. That is in the mornings and evenings. In the afternoon we relax. There are lots of things to do. One of the more interesting things will be to shoot sniper rifles under the tutelage of a fairly famous Navy Seal (I understand you are never an ex-Seal).

While I will be presenting, I expect that I will learn a lot more than I impart. It should make for a very interesting letter next week.

And speaking of Athens, I got a text from good friend Prieur du Plessis. Greece, he says, from the island beaches, is clearly not in crisis. But more close observation is needed. As I get on my plane I will pull out my latest International Living and dream about a little R&R.

And it is time to hit the send button. The conference is almost over and I will need to run to the airport and catch a plane back to Dallas and see my kids. It is going to be a good weekend. I see movies and Mimosas and grandkids in my future. I think brunch is set for 14. Have a great week!

Your still feeling like a kid analyst,

John Mauldin

The Chances of a Double Dip

JohnMauldin — Sat, 18 Sep 2010 03:39:00 GMT

The Chances of a Double Dip
Houston, My Book, and New York

I am on a plane (yet again) from Zurich to Mallorca, where I will meet with my European and South American partners, have some fun, and relax before heading to Denmark and London. With the mad rush to finish my book (more on that later) and a hectic schedule this week, I have not had time to write a letter. But never fear, I leave you in the best of hands. Dr. Gary Shilling graciously agreed to condense his September letter, where he looks at the risk of another recession in the US.

I look forward at the beginning of each month to getting Gary's latest letter. I often print it out and walk away from my desk to spend some quality time reading his thoughts. He is one of my "must-read" analysts. I always learn something quite useful and insightful. I am grateful that he has let me share this with you.

If you are interested in getting his letter, his website is down being redesigned, 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 Thoughts from the Frontline, and you will get an extra one month on your subscription. And now, let turn to Gary.

The Chances of a Double Dip

By Gary Shilling

Investor attitudes have reversed abruptly in recent months. As late as last March, most translated the year-long robust rise in stocks, foreign currencies, commodities and the weakness in Treasury bonds that had commenced a year earlier into robust economic growth - the "V" recovery.

As a result, investors early this year believed that rapid job creation and the restoration of consumer confidence would spur retail spending. They also saw the housing sector's evidence of stabilization giving way to revival, and strong export growth also propelling the economy. Capital spending, led by high tech, was another area of strength, many believed.

Not So Fast

But a funny, or not so funny, thing happened on the way to super-charged, capacity-straining growth. In April, investors began to realize that the eurozone financial crisis, which had been heralded at the beginning of the year by the decline in the euro, was a serious threat to global growth. Stocks retreated (Chart 1 ), commodities fell and Treasury bonds rallied and the dollar rose. It is, after all, just one big trade among these four markets, so their correlated actions on the down as well as the up side aren't surprising.

Furthermore, investors began to worry about the health of the U.S. economy and the prospects for a second dip in the Great Recession that started in December 2007. The gigantic 2009 fiscal stimuli of close to $1 trillion was running out, threatening a relapse in an economy that was running on government life support. The $8,000 tax rebate for new home buyers was expiring April 30 and might be followed by a drop in house sales as had its predecessor that expired in November 2009 as the spike in activity early this year only borrowed from future sales. The outlook for exports had turned negative with the robust buck, sagging European economies and the current "stop" phase of China's "stop-go" monetary and fiscal policies. With unemployment remaining high last spring, investors began to fret that consumer spending would falter as fiscal stimuli was exhausted.

Deleveraging

Although investor views of the economy have reversed in the last five months, the reality probably hasn't. The good life and rapid growth that started in the early 1980s was fueled by massive financial leveraging and excessive debt, first in the global financial sector, starting in the 1970s and in the early 1980s among U.S. consumers. That leverage propelled the dot com stock bubble in the late 1990s and then the housing bubble. But now those two sectors are being forced to delever and in the process are transferring their debts to governments and central banks.

This deleveraging will probably take a decade or more - and that's the good news. The ground to cover is so great that if it were traversed in a year or two, major economies would experience depressions worse than in the 1930s. This deleveraging and other forces will result in slow economic growth and probably deflation for many years. And as Japan has shown, these are difficult conditions to offset with monetary and fiscal policies.

The deleveragings of the global financial sector and U.S. consumer arena are substantial and ongoing. Household debt is down $374 billion since the second quarter of 2008. The credit card and other revolving components as well as the non-revolving piece that includes auto and student loans are both declining. Total business debt is down, as witnessed by falling commercial and industrial loans.

Meanwhile, federal debt has exploded from $5.8 trillion on Sept. 30, 2008 to $8.8 trillion in late August. Many worry about the inflationary implications of this surge, but the reality is that public debt has simply replaced private debt. The federal deficit has leaped as consumers and business retrenched, which curtailed federal tax revenues, while fiscal stimulus, aimed at replacing private sector weakness, has mushroomed.

Four Cylinders

As discussed in our May 2010 Insight, in the typical post-World War II economic recovery, four cylinders fire to push the economic vehicle out of the recessionary mud and back out on to the highway of economic growth. At present, only one - the ending of inventory liquidation - is generating significant power. The other three - employment gains, consumer spending growth and a revival in residential construction - are sputtering at best.

The Inventory Cycle

Historically, the liquidation of excess inventories accounts for major shares of the decline in economic activity in recessions. Around business cycle peaks, the sales of manufacturers, wholesalers and retailers begin to weaken but their managers can't tell whether that's the beginning of a major drop in business or just a minor dip in an upward trend. So they delay cutting production and orders until the downward trend is firmly established. Meanwhile, inventory-sales ratios leap as the numerators, inventories, rise and the denominators, sales, fall. That makes cuts in production and orders imperative and propels the economic downward trend in the process.

That was also the case in the Great Recession. In our view, it really started in early 2007 with the collapse in subprime residential mortgages, and then spread to Wall Street that summer with the implosion of the two Bear Stearns hedge funds in June. But these were financial declines, and recessions are measured by production, employment and spending, which are dominated by the goods and nonfinancial services segments of the economy. So the recession didn't officially start until December 2007.

Consumers Go On Strike

Furthermore, it wasn't until late 2008 that the collapse in home equity as house prices nosedived (Chart 2), rising layoffs (Chart 3) and the drying up of consumer lending drove consumers into retrenchment. But they suddenly went on a buyers strike in the last four months of 2008, and the results were leaps in inventory-sales ratios. Consequently, the cuts in inventories to get rid of unwanted stocks were far and away the biggest in the post-World War II era.

The reduction in inventory liquidation has been key to economic growth starting in the second half of 2009. In the third quarter of last year, it accounted for 66% of the 1.6% annual rate real GDP gain and 58% of the fourth quarter's 5.0% advance. The inventory-building in the first quarter of this year was responsible for 67% of the 3.7% annual rate rise in real GDP and 36% of the rise of 1.6% in the second quarter. In total, in the last four quarters, the inventory swing provided 58% of the 3.0% rise in real GDP.

Whether inventories will continue to hype the economy remains to be seen. As of June, the inventory-sales ratio for retailers had returned to its downtrend, but was still above trend for wholesalers and, especially, manufacturers. Furthermore, it's one thing to complete the liquidation of unwanted inventories but another to rebuild them significantly. The latter probably requires sales strength originating in other areas of the economy, and the other three cylinders of the economic engine aren't providing it in meaningful ways. Quite the opposite. It appears that recently disappointing retail sales have stuck merchants with unwanted goods that may be liquidated if consumers continue to retrench.

Employment Lags

In post-World War II recessions before the 1990-1991 decline, payroll employment's bottom came close to the low point in the overall business decline and was followed by rapid rebounds (Chart 4 ). In the mild 1990-1991 and even shallower 2001 recessions, however, the job market remained weak for over a year into economic recovery. The same is true this time, assuming the economic decline ended in July 2009, as many believe. What's changed?

It isn't that a shallow recession results in weak job recovery because even though the 1990-1991 and 2001 downturns were mild, the Great Recession certainly wasn't in terms of jobs (Chart 4). A more likely explanation is that globalization, starting in the 1980s, forced American business to cut all costs vigorously, including labor costs, by outsourcing to domestic and foreign suppliers, promoting productivity and curtailing hiring. This has been especially prevalent in the last decade.

Jobs Lost Forever

Despite the huge employment losses since the end of 2007, many of those jobs are unlikely to return. Of the 7.7 million net nonfarm jobs eliminated between December 2007 and July of this year, 86% were in construction, manufacturing, wholesale and retail trade, finance and leisure and hospitality. These six sectors accounted for 44.5% of nonfarm payrolls in July, only about half as much as their losses. Furthermore, job losses in those industries spawned employment losses in service and other sectors that depend on them. Home building, for example, spurs employment in the production of appliances, furniture, home furnishings and homeowner insurance and provides revenues that support state and local employment.

Given the gigantic overhang of excess house inventories and resulting further price declines, it will be years before residential construction shows any meaningful revival, as we've explained in past Insights and will update next month. Similarly, financially troubled and massively vacant commercial real estate will inhibit new construction and jobs for many years.

The inventory cycle did stabilize manufacturing employment in recent months, but that inventory-related bounce is over and the 2 million manufacturing jobs lost since December 2007, if anything, will probably become an even bigger number. Goods production continues to move offshore. job-reducing productivity gains continue in manufacturing, and consumer retrenchment and deflation will continue to curtail consumer durable goods consumption. Wholesale and especially retail trade will continue under pressure with the 25-year consumer borrowing and spending binge now replaced by a saving spree (Chart 5). That retrenchment as well as persistent business spending restraint will continue to retard jobs in leisure and hospitality.

Financial activities jobs stabilized with the March 2009-March 2010 revival of Wall Street, but the likely continuance of more recent weakness in many securities markets will lead to more layoffs and bonus cuts. The federal government, naturally, has added people, 262,000 since December 2007, as it expands in response to the weak economy. But state governments cut 6,000 on balance and local municipalities 128,000, largely in education.

Diligent Cost-Cutting

American business has been diligently cutting costs since the recession started in December 2007, especially labor costs. A recent survey shows that over half of adults have been affected by some combination of layoffs, wage and benefits cuts, involuntary furloughs and involuntary shifts to temporary jobs. Many may never be restored to their earlier statuses. Those layoffs lucky enough to find new jobs often are paid less than earlier.

About 20% of major employers with over 1,000 workers cut or eliminated their 401(k) plan contributions during the downturn but half have failed to restore them so far. Of those with 500 or fewer employees that cut contributions, only 36% have reinstated them or plan to in the next 12 months, according to a Fidelity Investments survey. Furthermore, 10% of all employers plan to reduce or eliminate matching 401(k) contributions in the next year.

Consumer Spending

All the layoffs, involuntary furloughs, and temporary jobs and benefit and wage reductions have been instrumental in the rebound in corporate profits, but devastating to employee compensation. This spells weakness for consumer spending. Also, consumers are no longer saving less and borrowing more on credit card, home equity and other loans to bridge the gap between income and desired spending growth. Furthermore, home equity has evaporated (Chart 6 ) and tight lending standards on credit card and other loans prevail. So they're on a saving spree and debt reduction binge, further slashing the outlook for consumer spending, the third cylinder that normally fires to propel economic recovery from recessions.

In fact, without massive fiscal stimuli, subdued compensation and the recession would have pushed consumer outlays down substantially. Our calculations show that consumers saved 80% of the tax rebates they received in the summer of 2008. And they initially saved 100% of 2009's tax cuts and special payments of $250 for each Social Security beneficiary. Those actions resulted in the spikes in the saving rate shown in Chart 5. This is remarkable since the tax cuts did not go to highincome people, normally the only big savers. Also, those folks are relatively few in number so they received few of the extra Social Security checks. Consequently, middle- and lower-income households stepped out of character to save heavily.

Households are deleveraging their balance sheets with a vengeance. Since the end of the fourth quarter of 2007 when stocks began to collapse, personal sector assets have fallen $3.0 trillion. Some $1.8 trillion was in equities and $277 billion in mutual funds due to losses on balance and withdrawals from equity direct ownership and from mutual funds. Investors put money into mutual funds on balance in January, March and April, but cut their holdings, especially in stock funds, in May and June. Also, private pension reserves fell $754 billion from the end of 2007 to the end of March 2010 and government pension reserves in household accounts were down $290 billion. Increases of Treasury bond holdings of $533 only partially offset the decline in government agency and securities of $593 billion. Meanwhile, liabilities of the personal sector dropped $500 billion, largely due to the decline in mortgage and consumer debt as some debts were repaid while others were written off as hopeless.

Support By Government

Since the recession began in December 2007 through June 2010, personal income from wages and salaries, proprietors' income, rents, interest, dividends and transfers such as pension benefits, Social Security, Medicare and Medicaid payments and unemployment insurance increased $285 billion. It would have declined $247 billion without a $532 billion increase in government transfer payments. These increases in government transfers also flowed through to Disposable Personal Income (after-tax income), which further benefited by lower personal taxes that fell $382 billion due to tax cuts and the lower taxable income resulting from layoffs, wage declines and bonus cuts.

In total, DPI was enhanced by $532 billion from the increase in government transfers and $382 billion from the lower taxes. Without these significant boosts, DPI would have fallen $247 billion since December 2007 instead of rising $667 billion. Without question, and much more so than in any previous post-World War II recession, the consumer has been supported by massive government money in the form of increased transfers and tax cuts. And these numbers do not include wages from jobs created by federal spending on infrastructure or saved by federal transfers to state and local governments to curtail teacher layoffs and other employment reductions.

Where Did The Money Go?

What happened to that $667 billion increase in DPI and what does it tell us about the likelihood of a chronic consumer saving spree? About 43% of it was spent and 64% saved, so maybe some of the earlier tax cuts were spent, but with delays. Nevertheless, a 64% marginal saving rate does seem to support our chronic saving spree thesis.

Also, in terms of spending and saving, note that whatever has been going on in the consumer arena has been supported by massive federal stimuli. Those stimuli may persist at near current levels in future years due to chronic high unemployment, as noted in earlier Insights, but seems unlikely to rise at the rates they did since the recession began due to their effects on the already massive federal deficits. Republicans and even some Democrats in Congress are so worried about the mushrooming deficit that current stimuli is unlikely to be renewed at least until unemployment leaps further. In that case, the resulting withdrawal of support for consumer outlays may push them down. So the leap in consumer spending as a share of personal income (Chart 7 ), which has been propelled by tax cuts that were only partially offset by saving increases, is highly unlikely to persist.

Evidence of recent consumer retrenchment is rampant. Consumer confidence has flattened as people worry about employment and income prospects as well as losses on their stocks and houses. Credit card loans outstanding fell 10% last year and promise to fall further as consumers repay debt, lending standards tighten and the new federal law cuts the profitability of credit card lending. Meanwhile, banks report that demand for consumer loans continues to drop, although at declining rates.

Increased saving is not only being used to repay debt but also to rebuild 401(k)s. Fidelity Investments found that in the second quarter, 5.3% of participants raised their contribution while 2.9% reduced them. That excess of increases over decreased has persisted for five quarters and follows three quarters of the reverse. Still, the numbers that tapped their accounts for loans or hardship withdrawals also rose.

Subdued Spending

On the spending side, vehicle sales in July were at an 11.5 million annual rate, up from the sub-10 million levels of 2008-2009, but well below the pre-recession levels. Consumer spending on TVs, computers, videos and telephone equipment rose 1.8% in the first half of 2010 compared with a year earlier while appliance purchases fell 3.6% and furniture outlays dropped 11%. Apparel sales also lost out to electronic gadgets. This shift reflects two forces. First, consumers are saving more and spending less on equipping their houses that are no longer appreciating but now depreciating assets. Second, they still want the satisfaction of buying iPads and other Small Luxuries, an investment theme we identified years ago and explained fully in our August Insight.

Housing Remains Depressed

The housing sector is an important generator of the normal economic recovery even though residential construction only accounts for 4.7% of GDP on average in the post-World War II years. It's the volatility that matters. Residential construction was 6.3% of GDP at its recent peak in the fourth quarter of 2005, but fell to 2.4% at its low in the first quarter of 2010. This 3.9 percentage point decline is very significant, considering that a 3% top to bottom decline in real GDP constitutes a major recession.

State and Local Government Spending

Spending by state and local governments is not one of the sources of economic revival after recessions end because it has been such a steady 12% to 13% share of GDP since the early 1970s. In the early post-World War II decades, it grew rapidly to finance the education of the postwar babies and the growth of mushrooming suburbs. Municipalities have also provided a steady source of jobs since, until recently, many fewer employees were laid off or fired than in the private sector and relatively few quit. Years ago, the "social contract" held that those employees received lower wages than private sector workers, so early retirement provisions and lush pensions allowed them to catch up in their later years. But since the early 1980s, the private sector has been globalized with very little growth in real incomes. Meanwhile, state and local government employees have continued to receive pay raises in excess of inflation and now have wages that are 34% higher than for private sector employees (Chart 8).

Federal Help

As part of its fiscal stimulus program, the federal government is transferring $246 billion to state governments to prevent more school teacher layoffs, help fund Medicaid cost increases and plug other holes in state budgets. Federal money is filling 30% to 40% of state budget gaps, but 46 states are projecting a collective deficit of $121 billion for the 2011 fiscal year that begins next July 1, equivalent to 19% of their budgets. And 39 states see gaps that total $102 billion for fiscal 2012. Unless federal assistance continues, these deficits will be much larger. All the states but Vermont are required to balance their budgets in one form or another, but most are honored in the breach as fiscal gimmicks and creative accounting get really creative.

Budget legerdemain no doubt is related to the rapid growth in state spending in recent years and leap in debt. State and local governments now use debt to fund investments that used to be done on a current budget basis, and some issue debt to cover up routine budget shortfalls. Total state and local bond debt outstanding leaped 93% between 2000 and 2009, from $1.2 trillion to $2.3 trillion.

It obviously takes a lot of gnashing of teeth in the outer darkness for state and local government to flatten, much less cut, their spending after a decade of 6% to 7% annual growth rates. Jumping municipal employment is the main reason for mushrooming spending in earlier years, and cutting often unionized state and local workforces is very difficult. Since the Great Recession started in December 2007 through April, private payroll employment has dropped 6.8%. Still, state and local jobs have declined but by much less, only 1.4%. In July, state and local governments, which employ 9.5 million, cut 48,000 jobs, 102,000 in the past three months and 169,000 so far this year.

Raise Taxes

In reaction to their financial woes, many state and local governments have attempted to raise taxes and fees. The usual suspects include higher sin taxes on tobacco and alcoholic beverages as well as taxes on companies based out of state but doing some business in the state. Attempts to raise taxes and cut spending have proved wholly inadequate to solving state and local government funding problems. And those woes appear chronic, especially if our forecast of slow economic growth and even deflation is valid. Rises in taxable personal and corporate incomes will be muted. Retail sales and taxes on them will be sluggish as consumers persist for the next decade in their saving spree, replacing the borrowing and spending binge of the last decade.

House prices are likely to fall further in the next year or so, under the weight of gigantic excess inventories. Even when those inventories are worked off, house prices will probably rise little, if at all, in a low inflation or deflationary climate. Historically, they've been flat after correcting for overall inflation and the growing size of houses over time. And now that house prices have fallen nationwide for the first time since the 1930s, home buyers no longer see their abodes as also great, leveraged investments, and want smaller, cheaper houses. That will also reduce assessments on property taxes.

Meanwhile, commercial real estate high vacancies and severe financial problems will take years to resolve, keeping prices depressed for some time (Chart 9 ). So, all things considered, local government property taxes are likely to be curtailed for many years. Meanwhile, municipal expenses will be hard to cut. Chronic high unemployment will spawn high Medicaid enrollment and costs. Welfare and unemployment benefit costs will no doubt rise as well.

Deteriorating finances are raising the risks of defaults on state and local obligations and even municipal bankruptcies. Harrisburg, Pennsylvania's capital, will not make a $3.3 million municipal bond payment on $51.5 million debt that's due in two weeks, and earlier this year, city officials discussed bankruptcy. Harrisburg also lacks the funds to continue payments for the $288 million debt on an incinerator project. Earlier, Jefferson County, Ala., home of Birmingham, defaulted on $227 million due on its disastrous sewer upgrades.

Taxpayer Revolt?

People working in the private sector apparently were willing to accept the higher pay, more job security and better retirement benefits for state and local employees in past years. High employment in the private sector and robust economic growth at least held out the hope that their lots would improve tomorrow. But with slow economic growth, limited income expansion and high unemployment now expected by them for years, voter attitudes appear to be changing.

Americans still want basic municipal services like police and fire protection, good schools for their kids, clean streets and garbage collection. But they apparently are deciding they're paying too much for those services; that 34% higher wages for state and local employees compared to private sector workers isn't justified as pay cuts multiply in the private sector and those laid off earn much less if and when they can find another job; that 66% higher benefit costs is over the top, especially as private sector employees are paying more of their health care premiums and seeing their defined benefit pension plans replaced by much more uncertain 401(k)s.

As taxpayers revolt, there are plenty of things that can be done to reduce state and local government costs in an orderly way. Following in the footsteps of bankrupt GM, two-tier wage structures are being established with existing employees continuing at current salary levels, but new hires paid the much lower wages adequate to attract qualified people. And the new people are enrolled in defined contribution pension plans that require employee contributions, not defined benefit plans, while their retirement ages are increased.

Foreign Trade

Another economic sector that normally isn't a significant engine of economic recovery but is important at present is exports since the Administration hopes they will double in the next five years and provide meaningful economic growth. The President's zeal to achieve that goal rises as he realizes that massive fiscal stimuli have not revived the economy, and already-huge federal deficits impede further rounds of big spending.

But two significant problems are likely to retard export growth in future years - rising protectionism that clearly impedes foreign trade, and finding foreign countries that will buy this doubling of American exports. It's like the story of the stockbroker who calls his client during May's Flash Crash to tell him that stocks are collapsing. "Sell my entire portfolio!" yells the distressed client. "Sure," retorts the broker, "but to whom? There are no buyers."

Foreign Buyers?

As far as foreign buyers of U.S. exports is concerned, the reality is that many of those markets that are showing robust growth and therefore might be able to absorb American products, lands like China and Germany, are major exporters themselves, not importers on balance. Indeed, it's no surprise that the EU's measures of both industry and household confidence shows that export-led Germany has the highest level while the economically weak Club Med net importers are at the bottom of the pile (Chart 10).

Currency changes have only limited effects on export or import prices. The volatility of U.S. import prices is only about one-fourth that of the dollar and a third in the case of American export prices. Why? Many products are sold under long-term contracts and immune from most currency fluctuations. Also, importers and exporters resist reflecting the full extent of exchange rate changes in their prices. If the yen is strong against the dollar, importers of Lexus cars shave their profit margins to offset some of the higher prices in dollars to avoid losing market share. Conversely, U.S. exporters to Japan don't pass on in lower yen prices the full extent of the dollar's decline in order to increase their profits.

The "processing trade" in which components are imported, assembled and then re-exported makes up about half of Chinese exports. This reduces the importance of the yuan's exchange rates. Furthermore, even goods with more domestic content aren't completely sensitive to exchange rates in a global world. About 50% of a Chinese manufacturer of children's clothes costs are fabric and around 50% of the fabric's costs are cotton, a globally-traded commodity priced in dollars. So, 25% of the total cost is not affected by yuan fluctuations. Also, another 25% might be in the combined profits of the clothing and the fabric producers, and could be adjusted to offset currency fluctuations - or production moved to lower-cost Vietnam or Bangladesh if the yuan leaped in value.

Double Dip Recession?

We've made our case for very slow U.S. economic growth in the quarters, indeed the years, ahead. The economic rebound due to the inventory cycle is over. Employment and consumer spending remain weak. Housing is too overburdened with excess inventory and the resulting price weakness to revive any time soon. State and local government spending and employment are retreating. And meaningful export gains are unlikely as economic growth abroad slips. Interestingly, the consensus forecast is moving toward our position as growth estimates have been reduced rapidly in recent months. In both April and June, the Wall Street Journal's poll of economists (not including us) expected 3% economic growth in the second half of this year. We wonder if they still do.

Will slow growth deteriorate into another recession, the so-called double dip scenario? Before exploring that question, let's define a double dip. It seems to mean a second period of economic decline following the 2007-2009 nosedive. That could imply that the recession that the accepted authority, the Business Cycle Dating Committee of the nonprofit National Bureau of Economic Research, pinpointed as commencing in December 2007, is still underway. Sure, real GDP grew in the last four quarters, but it's common to have quarters of gain within recessions. In the 11 post-World War II recessions so far, seven, including the 2007- 2009 decline, had at least one quarter of rising real GDP within the recession. In fact, two - the 1960-1961 and the 2001 declines - didn't even have two quarters of consecutive decline. Even in the 1929-1933 economic collapse, GDP rose in six quarters.

Still, to have a four-quarter interlude between the declining phases of the same recession would be unprecedentedly long, assuming that real GDP declines in the current quarter. So another period of economic weakness could be classified as a second recession, much as the 1981-1982 decline, which started in July 1981, only 12 months after the 1980 recession ended.

Slow Growth to Recession

We're on record for a 50% or higher probability of a second dip or another recession, whatever it would be called. The composition of the ECRI Weekly Leading Index remains proprietary, but its growth rate has fallen to the level that in the past was always associated with recessions (Chart 11). Historically, however, recessions have been propelled by shocks. The post- World War II downturns prior to 2001 were caused by Fed tightening in response to threats of economic overheating and the resulting higher inflation. Since then, other shocks have been responsible. The 2001 recession resulted from the 2000 collapse of the dot com bubble augmented by the 9/11 shock. The 2007-2009 downturn resulted from the collapse in subprime residential mortgages that commenced early in 2007.

In the current economic and financial climate, it's highly unlikely that the Fed will tighten credit for years. In fact, the central bank has shifted from planning last spring to withdraw liquidity as the economy grew to renewing quantitative easing and worrying about deflation and subpar growth. It said after its August 10 policy meeting that household spending is being retarded by high unemployment, slow income growth, lower home equity and tight credit conditions while bank lending "has continued to contract."

Pushing On A String

Conventional monetary ease is now impotent with the federal funds rate close to zero , the money multiplier collapsed and banks sitting on hoards of cash (Chart 12) and over $1 trillion in excess reserves. Sure, large banks report to the Fed that they are easing lending standards for small business, but after the intervening financial crisis, many fewer potential borrowers are deemed creditworthy than in the loose lending days. Furthermore, the small business trade group, the National Federation of Independent Business, reports that 91% of small business owners have had their credit needs met or business is so slow that they don't want to borrow. The Fed is pushing on the proverbial string.

The Fed also worries about deflation, which means that even zero interest rates are positive in real terms, as has been the case for years in deflationary Japan. Also, deflation encourages buyers to wait for still-lower prices in a self-feeding cycle, as is seen in Japan and as we have discussed often in conjunction with our forecast of 2% to 3% per year chronic deflation. In it s post- August 10 meeting statement, the Fed said that "measures of underlying inflation," already low, "have trended lower" lately and are "likely to be subdued for some time." James Bullard, President of the Federal Reserve Bank of St. Louis, recently warned of the risks of deflation.

Deflation is a scary phenomenon, but we can't resist noting that the Fed as well as many other forecasters are moving in the direction of our forecast. In contrast, an April 6 Wall Street Journal piece by Peter Eavis stated unequivocally, "No one in their right mind would bet on inflation remaining substantially below 4% for the next 10 years." Maybe we better have our head examined.

A Baby Step

So, with conventional monetary ease exhausted and further fiscal stimulus on hold because of the already-huge federal deficit, the Fed at its August 10 meeting took a baby step toward more quantitative ease by deciding to buy Treasury bonds to replace the maturing and refinanced Treasury and mortgage-backed securities in the $1.7 trillion hoard it finished buying earlier this year. With low mortgage rates, refinancings were projected to raise the Fed's portfolio contraction from an earlier estimate of $200 billion by the end of 2011 to $340 billion, with another $55 billion coming from retirement of Fannie Mae and Freddie Mac debt held by the Fed.

Furthermore, the Fed is open to further steps if the economy continues to slip. It could buy even more Treasurys or mortgage debt. But would the resulting lower interest rates encourage prospective home buyers who now know that house prices can and do fall? Would another $1 trillion in excess reserves induce more bank lending than the first $1 trillion? The Fed could also promise to keep short-term interest rates low, but it's already said it would for an "extended period."

It could cut out the 0.25% it pays the banks on their reserves, but would that induce reluctant banks to lend? Finally, the Fed could set an inflation target over its formal 1.5% to 2.0% range. That would be anathema for inflation-wary central bankers, and how could the Fed hit that target in a deflationary world where ample supply exceeds weak demand? Despite all the credit easing actions that Chairman Ben Bernanke, in his famous November 2002 speech, said the Fed could take if the federal funds target reached zero, the credit authorities are about out of ammo - except for dumping money out of helicopters. Remember the "Helicopter Ben" moniker?

Other Shocks

If the Fed is highly unlikely to shock slow growth into recession, what could? This brings us back to the series of seemingly isolated events that are occurring on the deleveraging road, such as further financial woes in Europe, a crisis in commercial real estate, a nosedive in the Chinese economy and a slow motion train wreck in Japan. They are all possibilities - as are other shocks here or abroad that we don't foresee. Maybe the exhausting of federal stimulus will be enough to trigger an economic downturn. Keep your eyes pealed, however, because it won't take much disruption to push the fragile global economy back into decline.

Houston, My Book, and New York

Tuesday was a very special day. My co-author, Jonathan Tepper of Variant Perception (based in London), and I spent the entire day reading the first complete rough draft of our forthcoming book, The End Game. We went cover to cover, making comments and notes. Of course, I had read the bits and pieces, but not in one sitting. I have to say that I am more than happy. It is a very good first draft, much better than I thought it would be. There is a lot of work ahead, of course, to try and make it a great book, but I can "feel" it. And I think we have managed to capture some very difficult topics and make them simple and maybe even a fun read. We are on target for a January 1 launch.

We make what I feel is an overwhelming case for a period of slow growth in the developed world, with more volatility as the base case. The research we review is very strong. But there are pockets of potential if you step back and take off your localized blinders.

I will be in Houston (along with Gary Shilling, David Rosenberg, Bill King, and Jon Sundt) at the one-day X-Factor Conference on October 1. Quite the lineup. You can learn more by going to www.streettalklive.com. Then I will be in New York in late October, speaking at the BCA conference and a few media events.

It has been interesting talking with investment types in Europe. They are very curious about the US and what they perceive as our lack of seriousness about the deficit. It appears that Greece has focused their attention. And of course, I get off the plane from Malta yesterday and the headline in the Financial Times says, "Greece rules out possibility of default." I know that made me feel better. And gave us all a laugh. If you have not, read the piece from Michael Lewis in Vanity Fair on Greece. And then share my amusement about the chances of no default.

It is time to hit the send button. I feel a nap coming on. Jet lag has been worse than normal this trip. And maybe another glass of Prosecco to ease me into slumberland.

Your excited about almost finishing this book analyst,

John Mauldin

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

JohnMauldin — Mon, 18 Jan 2010 18:28:55 GMT

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.

Slow Long-Term Growth, And Government's Response

JohnMauldin — Mon, 10 Aug 2009 20:50:00 GMT

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

John Mauldin, Editor
Outside the Box

Slow Long-Term Growth, And Government's Response

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

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

Six Causes of Slow Long-Term Growth

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Slow And Weak Recovery

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

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

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

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

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

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

2.0% GDP Growth

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

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

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

Consumer Spending Growth

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

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

Consumption vs. GDP

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

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

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

Where's The Growth?

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

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

Capital Spending

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

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

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

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

Imports and Exports

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

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

State and Local Government Spending

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

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

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

Rescued By Slow Productivity

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

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

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

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

Big Federal Spending

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

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

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

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

Savers To The Rescue

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

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

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

Debt Reduction

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

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

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

Future Insights

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

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

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