Are we Heading for a Major Downmove in the Economy?
That is a difficult question to answer but I would believe that the present conditions indicate that such a major down move is very likely.
At last we have the markets correcting (as the conventional wisdom would say), but since I tend to take up a more unconventional (and always a hated stance), I would think that we are at the throes of the start of a bear market. Undoubtedly, this is very early days in the start of the bear run, though I am willing to stick my neck out and call the start of a bear market. I think the world has seen the best of the economic growth story and now starts the “Age of Pain”, which could last about 3-5 in the west. It is important to note that the pain will not be equally spread out over the whole world. There will be pockets of growth (as there will be pockets of pain). Economy and the markets are always a Zero sum game. One winner needs at least one loser, though in the markets the proportion of winners and losers is disproportionate.
I had confidently asserted about a year back that the bounce would be temporary, and about six months back had clearly stated that the second half of the 2010 will be horrible – to put it politely. Therefore, I was considered to be a part of the lunatic fringe and was actually called a number of names (only a few directly and mostly behind my back). Now I stand vindicated. Sadly, it required the loss of nearly US$1.9 trillion of market cap, though I hope it would have been less scary. Interestingly, I am not exactly in a panic mode, since I have had the time to reflect on strategies that would enable anybody who listens to survive and actually take advantage.
Every Dawn compounds our problems:
The problem with the world’s economy is that the margin of safety that exists is almost nil. We need one incident even if it quite small, to boomerang all over the world causing great pain and billions of dollars of losses. Each of these losses may not seem too large at a cursory glance, but cumulatively they are slowly destroying even the best companies. When the best are going to see cash dissolve from their balance sheets, it is a matter of time before the smouldering mass of combustible material explodes. The most recent example is BP, where a loss that was erroneously estimated at a loss of 5000 barrels of oil a day now has the potential to cost damages that may exceed US$20 billion over the next 5-10 years. Undoubtedly, BP can overcome this problem, but not another few of such magnitude. What are the probabilities of such Black Swan events in the future? I believe quite high as we have had nearly 2 years of relentless cost cutting where companies are most likely to have cut off the muscle and bone rather than fat. Most of the companies are led by entrepreneurs who are more prone to either selective amnesia or hype (or fear) created by the media. A number of them still continue to believe that they can borrow their way to prosperity despite the fact that we are in an era of structural change where I am almost certain that the age of low interest rates have come to a close. The only way the low interest rate regime can be continuously perpetuated is by printing ever exponentially large amounts of money year after year for the next 10 years – an unlikely event. The next two years will see an increase in printing money but not beyond that.
Why I continue to bearish on the real economy:
It is pertinent to note that the present note, deals mostly with the logic behind my bear-case analysis on the real economy and not the financial markets. For the time being, it is important to overlook the financial markets as they are dominated by speculative capital flows, which are in turn an offshoot of easy liquidity conditions perpetuated by the Central Banks. The main reasons are enunciated in the following pages.
The Red Flags:
The problem areas in the world economy are well known and have not changed since the start of 2010. The problems are however, being accentuated by the inertia of the policy makers to undertaken drastic changes that are required. The problems at the present juncture include,
(a) A likely recession in the West.
(b) Deterioration in the US economy
(c) Accelerating problems in European Sovereign Debt Issues
(d) Slowing China
(e) Insolvency of the banking systems of Europe
(f) Pressure to cut deficits.
(g) Gradual (future) deterioration of the financial sector over the next one year (this would include the banking, non-bank finance companies as well as the insurance companies).
In all likelihood we are about to witness a relapse of the western world into a recession. While it may be too early to claim that the whole west may relapse into a recession, I would bet that the USA and large parts of Europe are likely to relapse into a recession in the next one year. The news that has emanated from different parts of the world is clearly indicative of either economies that are topping or those that already have seen their peak performance. Interestingly, in an era of government cost cutting everybody seems to think that the best way to overcome the recession would be export their way out of troubles. One only is forced to wonder, who will be the consumer, since most of the world is highly indebted and those who are not indebted have no intention of taking on more debt.
US Economy: Recession, Highly likely
A recession is quite likely in USA unless it is aided by fortituous circumstances (that we don’t know as it) or unless there is a large statistical jugglery. The deterioration of the balance sheet of the US consumer continues abated as does the deterioration of the balance sheets of the US states, most of which have to cut their budgets by at 20% this year (over the previous) ones. The recent Household survey indicated that the total employment fell by about 35,000. The unemployment rate did come down, but that was largely because of statistical anomalies rather than real improvement in the economy. This was because the US labour force actually declined by 322,000. It has been pointed out that nearly half a million people have simply disappeared from the way US labour force statistics, because of the peculiar way in which the US calculates its unemployed. The four-week moving average (which is more reliable) continues to consistently show that the job losses continue to remain at 100,000 a week. This time we remain short of the old peak of employment, by an astounding 8.4m jobs. One in six Americans is either unemployed or underemployed. This is not a normal cycle when compared with a typical recession, which sees no more than 2m to 3m jobs lost. The average duration of unemployment rose to 34.4 weeks from 33 weeks in April. This is taking place when the number of hours worked has increased from 0.3% and wages declined.
Consumers continue to be in a bad shape and are becoming more and more despondent, so it is unlikely that they would spend go back to their old spending habits. The mood of US households is despondent. In May only 11.3 per cent believed they would see their income rise in the following six months, while 16.6 per cent thought they would see it decline. The May retail sales are quite indicative of the larger trend, when the year-on-year Chain store sales rose 2.5% (which was about 1.5% less than the consensus estimates). Moreover, last in last May the US was just witnessing the positive impact of the huge US government rescue packages. Interestingly, only about 54% of the retailers in the USA managed to beat their lowered sales targets, while those like Wal Mart clearly indicated that the economy was too soft for their comfort. Half of the US employers froze pay for at least a part of their workforce in the past year and about 13% actually cut salaries for their workforce.
One of the critical reasons why we are betting on a high probability of recession in the west are based on the movement of the bond markets, and the commodity markets – both of them are indicating turbulent times ahead. Manufacturing in the US may have already peaked or will peak in the next one month. Manufacturing new orders increased by about 1.2% over April, while the consensus was for an increase of about 1.8%. This is worrisome as it is clear that the recent growth was largely because of the rise in manufacturing may only have been inventory restocking, which may now be coming to an end.
Another important source of concern about the state of the world economy is the acceleration in the concern about the problems and issues related to sovereign debt. The last in the list of concerns is Hungary. There are growing fears that Belgium is doing precious little to solve its problem of indebtedness. This led to jump in interest rates on the 10-year bond from 3.15 to 3.50 percent (Belgium’s debt is now 99% of the GDP). The only likely solution that seems to exist (which nobody is interested in at the present) is a default by Greece and at least another one or two countries). The major panic is likely to occur as there is a persistent increase in the probability of a default rises. I believe that such a forecast would become more mainstay by the end of 2011 (that should be sufficient time for the Morons - twenty something traders to fully understand the internal dynamics of the state). The recent statement by the UK PM that they should expect huge cost cutting that would be ‘generational in nature’ should give rational investors what they could expect over the next few years. One option that the UK government is seriously considering is to cut its budget spending by 20% per year for the next three years, akin to what Canada did in 1994. This the PM claims is because the debt level of about 156 billion pounds is unsustainable. He is correct, but so are the cuts as they will bring unimaginable suffering to the people with the consequence being a recession. While Canada got away, I am not so sure about UK for the simple reason, that in 1994 consumer leverage was barely starting and the world was a different place then. Moreover, Canada did not carry such a large debt as UK. According to the British Prime Minister, Britain’s national debt stands at 770 billion Pounds and is expected to touch 1.4 trillion Pounds within five years – or 22,000 pounds for every man, woman and child in the country.
The government cutting in fiscal deficit along with the problems in the banking system will only create a perfect storm of another crisis. European banks have insufficient capital. SocGen has estimated that European banks have to raise US$357 billion of additional capital. This figure will only increase as more assets grow bad. The banks probably have a reasonably good idea as to which assets will go bad in the foreseeable future, and it is for that they are not lending. Interestingly the era of counter party risk is back on the table and banks are not even lending to other banks, let alone other borrowers. Overnight deposits with the ECB has increased by Euros351 billion, the highest since the establishment of the Euro, this was a jump from about Euro 300 billion the previous day. However, the financial buffer for most of the corporate sector (especially in the USA) is much better as a large number of them have borrowed sufficient amount of cash that would probably last for about a year, along with the cash flows that they generate in their business). It is for this reason that I believe that the problems will reach crisis proportions more slowly. As assets grow bad we are likely to witness the need for banks to come with more capital. The largest rally since 1930s led to the problem of the banks taking a backstage as most of the asset prices rose. This provided a false sense of security. This problem will come back to haunt the banks in the very near future.
Lower interest rates are simply not working, at least not with the consumer. Mortgage rates were actually down in May by about 15 basis points and the result: mortgage applications for new homes crash to a 13 year low. See the chart in the Charts section (Charts Tell Another Story).
There is simply too much complacency amongst business that China can provide the valuable cushion to the rest of the world. More importantly, the estimates about the corporate sector profitability is too high and it would have to be revised downwards very soon. This downward revision will invariably mean that the markets will have to grapple with another down draft. The problem with falling markets is that it would open a can of worms, which will probably increase the stranglehold. Credit shortages will lead to a rise in the cost of carrying out business, just at a time when companies have no pricing power and when their margins are being squeezed due to volatility in the currency and commodity markets. Where exactly is the pain threshold, is a fact that very few know and even if they know, very few would be willing to admit until it is too late.
Investors losing more will lead to more panics:
American equities have lost nearly US$1.9 trillion dollars of market capitalisation since April 23, 2010. A number of hedge funds have been burned because they bet on the rise of inflation and betting on a continuation of narrow credit spreads. The age-old dictum, those who forget history are condemned to repeat it still holds true even to this day. During the 1990s, investors were burned because they bet on a Japanese recovery. Now, shorting US Treasuries has led to huge losses, which will only come out in time. Hedge funds fell by 2.6% last month, the largest drop since November 2008. These losses may lead to a situation where funds and investors will have to sell profitable holdings in order to pay for their mark-to-market requirements or simply to provide more collateral for their trades. This could in turn set off losses in asset classes such as Gold and Silver, though one is not sure as to how severe the cash requirement or loss are as it would vary from fund to fund.
Gold:
The bull market in gold has more legs, but in the short term expect a pull back. I would not be surprised if a meaningful pull back starts sometime in the fourth quarter of 2010 rather than immediately. This bullishness is the result of a rather simple logic. Investors, the world over, are over invested in equities and under invested in bonds and Gold. Bonds are troubling because investors are stuck with a never-ending list of shoes that may be the next in line, hence the more prudent probably prefer gold to others. The world’s liabilities are nearly US$220 trillions (public and private sector) and the US has had to pump in US$2 trillions for a GDP growth of about US$200 billion. Thus, the law of diminishing returns for large money printing is quite advanced as far as the real economy is concerned. More importantly, only about 0.05% of the share of household networth is in gold. So all we need is about another 0.01% of new buying and gold can shoot up by another 50% since the markets are actually quite shallow. There are sufficiently scared millionaires in the world, who don’t know where to put their money. Ten Kilos of gold will easily be hidden in a bank locker.
Sting is in the tail
The latest Investors Intelligence poll for the past week showed the first rise in bullish sentiment since early May - up to 39.8% from 39.3%, while there are only 28.4% bears, down from 29.2% last week.
I had confidently asserted about a year back that the bounce would be temporary, and about six months back had clearly stated that the second half of the 2010 will be horrible – to put it politely. Therefore, I was considered to be a part of the lunatic fringe and was actually called a number of names (only a few directly and mostly behind my back). Now I stand vindicated. Sadly, it required the loss of nearly US$1.9 trillion of market cap, though I hope it would have been less scary. Interestingly, I am not exactly in a panic mode, since I have had the time to reflect on strategies that would enable anybody who listens to survive and actually take advantage.
Every Dawn compounds our problems:
The problem with the world’s economy is that the margin of safety that exists is almost nil. We need one incident even if it quite small, to boomerang all over the world causing great pain and billions of dollars of losses. Each of these losses may not seem too large at a cursory glance, but cumulatively they are slowly destroying even the best companies. When the best are going to see cash dissolve from their balance sheets, it is a matter of time before the smouldering mass of combustible material explodes. The most recent example is BP, where a loss that was erroneously estimated at a loss of 5000 barrels of oil a day now has the potential to cost damages that may exceed US$20 billion over the next 5-10 years. Undoubtedly, BP can overcome this problem, but not another few of such magnitude. What are the probabilities of such Black Swan events in the future? I believe quite high as we have had nearly 2 years of relentless cost cutting where companies are most likely to have cut off the muscle and bone rather than fat. Most of the companies are led by entrepreneurs who are more prone to either selective amnesia or hype (or fear) created by the media. A number of them still continue to believe that they can borrow their way to prosperity despite the fact that we are in an era of structural change where I am almost certain that the age of low interest rates have come to a close. The only way the low interest rate regime can be continuously perpetuated is by printing ever exponentially large amounts of money year after year for the next 10 years – an unlikely event. The next two years will see an increase in printing money but not beyond that.
Why I continue to bearish on the real economy:
It is pertinent to note that the present note, deals mostly with the logic behind my bear-case analysis on the real economy and not the financial markets. For the time being, it is important to overlook the financial markets as they are dominated by speculative capital flows, which are in turn an offshoot of easy liquidity conditions perpetuated by the Central Banks. The main reasons are enunciated in the following pages.
The Red Flags:
The problem areas in the world economy are well known and have not changed since the start of 2010. The problems are however, being accentuated by the inertia of the policy makers to undertaken drastic changes that are required. The problems at the present juncture include,
(a) A likely recession in the West.
(b) Deterioration in the US economy
(c) Accelerating problems in European Sovereign Debt Issues
(d) Slowing China
(e) Insolvency of the banking systems of Europe
(f) Pressure to cut deficits.
(g) Gradual (future) deterioration of the financial sector over the next one year (this would include the banking, non-bank finance companies as well as the insurance companies).
In all likelihood we are about to witness a relapse of the western world into a recession. While it may be too early to claim that the whole west may relapse into a recession, I would bet that the USA and large parts of Europe are likely to relapse into a recession in the next one year. The news that has emanated from different parts of the world is clearly indicative of either economies that are topping or those that already have seen their peak performance. Interestingly, in an era of government cost cutting everybody seems to think that the best way to overcome the recession would be export their way out of troubles. One only is forced to wonder, who will be the consumer, since most of the world is highly indebted and those who are not indebted have no intention of taking on more debt.
US Economy: Recession, Highly likely
A recession is quite likely in USA unless it is aided by fortituous circumstances (that we don’t know as it) or unless there is a large statistical jugglery. The deterioration of the balance sheet of the US consumer continues abated as does the deterioration of the balance sheets of the US states, most of which have to cut their budgets by at 20% this year (over the previous) ones. The recent Household survey indicated that the total employment fell by about 35,000. The unemployment rate did come down, but that was largely because of statistical anomalies rather than real improvement in the economy. This was because the US labour force actually declined by 322,000. It has been pointed out that nearly half a million people have simply disappeared from the way US labour force statistics, because of the peculiar way in which the US calculates its unemployed. The four-week moving average (which is more reliable) continues to consistently show that the job losses continue to remain at 100,000 a week. This time we remain short of the old peak of employment, by an astounding 8.4m jobs. One in six Americans is either unemployed or underemployed. This is not a normal cycle when compared with a typical recession, which sees no more than 2m to 3m jobs lost. The average duration of unemployment rose to 34.4 weeks from 33 weeks in April. This is taking place when the number of hours worked has increased from 0.3% and wages declined.
Consumers continue to be in a bad shape and are becoming more and more despondent, so it is unlikely that they would spend go back to their old spending habits. The mood of US households is despondent. In May only 11.3 per cent believed they would see their income rise in the following six months, while 16.6 per cent thought they would see it decline. The May retail sales are quite indicative of the larger trend, when the year-on-year Chain store sales rose 2.5% (which was about 1.5% less than the consensus estimates). Moreover, last in last May the US was just witnessing the positive impact of the huge US government rescue packages. Interestingly, only about 54% of the retailers in the USA managed to beat their lowered sales targets, while those like Wal Mart clearly indicated that the economy was too soft for their comfort. Half of the US employers froze pay for at least a part of their workforce in the past year and about 13% actually cut salaries for their workforce.
One of the critical reasons why we are betting on a high probability of recession in the west are based on the movement of the bond markets, and the commodity markets – both of them are indicating turbulent times ahead. Manufacturing in the US may have already peaked or will peak in the next one month. Manufacturing new orders increased by about 1.2% over April, while the consensus was for an increase of about 1.8%. This is worrisome as it is clear that the recent growth was largely because of the rise in manufacturing may only have been inventory restocking, which may now be coming to an end.
Another important source of concern about the state of the world economy is the acceleration in the concern about the problems and issues related to sovereign debt. The last in the list of concerns is Hungary. There are growing fears that Belgium is doing precious little to solve its problem of indebtedness. This led to jump in interest rates on the 10-year bond from 3.15 to 3.50 percent (Belgium’s debt is now 99% of the GDP). The only likely solution that seems to exist (which nobody is interested in at the present) is a default by Greece and at least another one or two countries). The major panic is likely to occur as there is a persistent increase in the probability of a default rises. I believe that such a forecast would become more mainstay by the end of 2011 (that should be sufficient time for the Morons - twenty something traders to fully understand the internal dynamics of the state). The recent statement by the UK PM that they should expect huge cost cutting that would be ‘generational in nature’ should give rational investors what they could expect over the next few years. One option that the UK government is seriously considering is to cut its budget spending by 20% per year for the next three years, akin to what Canada did in 1994. This the PM claims is because the debt level of about 156 billion pounds is unsustainable. He is correct, but so are the cuts as they will bring unimaginable suffering to the people with the consequence being a recession. While Canada got away, I am not so sure about UK for the simple reason, that in 1994 consumer leverage was barely starting and the world was a different place then. Moreover, Canada did not carry such a large debt as UK. According to the British Prime Minister, Britain’s national debt stands at 770 billion Pounds and is expected to touch 1.4 trillion Pounds within five years – or 22,000 pounds for every man, woman and child in the country.
The government cutting in fiscal deficit along with the problems in the banking system will only create a perfect storm of another crisis. European banks have insufficient capital. SocGen has estimated that European banks have to raise US$357 billion of additional capital. This figure will only increase as more assets grow bad. The banks probably have a reasonably good idea as to which assets will go bad in the foreseeable future, and it is for that they are not lending. Interestingly the era of counter party risk is back on the table and banks are not even lending to other banks, let alone other borrowers. Overnight deposits with the ECB has increased by Euros351 billion, the highest since the establishment of the Euro, this was a jump from about Euro 300 billion the previous day. However, the financial buffer for most of the corporate sector (especially in the USA) is much better as a large number of them have borrowed sufficient amount of cash that would probably last for about a year, along with the cash flows that they generate in their business). It is for this reason that I believe that the problems will reach crisis proportions more slowly. As assets grow bad we are likely to witness the need for banks to come with more capital. The largest rally since 1930s led to the problem of the banks taking a backstage as most of the asset prices rose. This provided a false sense of security. This problem will come back to haunt the banks in the very near future.
Lower interest rates are simply not working, at least not with the consumer. Mortgage rates were actually down in May by about 15 basis points and the result: mortgage applications for new homes crash to a 13 year low. See the chart in the Charts section (Charts Tell Another Story).
There is simply too much complacency amongst business that China can provide the valuable cushion to the rest of the world. More importantly, the estimates about the corporate sector profitability is too high and it would have to be revised downwards very soon. This downward revision will invariably mean that the markets will have to grapple with another down draft. The problem with falling markets is that it would open a can of worms, which will probably increase the stranglehold. Credit shortages will lead to a rise in the cost of carrying out business, just at a time when companies have no pricing power and when their margins are being squeezed due to volatility in the currency and commodity markets. Where exactly is the pain threshold, is a fact that very few know and even if they know, very few would be willing to admit until it is too late.
Investors losing more will lead to more panics:
American equities have lost nearly US$1.9 trillion dollars of market capitalisation since April 23, 2010. A number of hedge funds have been burned because they bet on the rise of inflation and betting on a continuation of narrow credit spreads. The age-old dictum, those who forget history are condemned to repeat it still holds true even to this day. During the 1990s, investors were burned because they bet on a Japanese recovery. Now, shorting US Treasuries has led to huge losses, which will only come out in time. Hedge funds fell by 2.6% last month, the largest drop since November 2008. These losses may lead to a situation where funds and investors will have to sell profitable holdings in order to pay for their mark-to-market requirements or simply to provide more collateral for their trades. This could in turn set off losses in asset classes such as Gold and Silver, though one is not sure as to how severe the cash requirement or loss are as it would vary from fund to fund.
Gold:
The bull market in gold has more legs, but in the short term expect a pull back. I would not be surprised if a meaningful pull back starts sometime in the fourth quarter of 2010 rather than immediately. This bullishness is the result of a rather simple logic. Investors, the world over, are over invested in equities and under invested in bonds and Gold. Bonds are troubling because investors are stuck with a never-ending list of shoes that may be the next in line, hence the more prudent probably prefer gold to others. The world’s liabilities are nearly US$220 trillions (public and private sector) and the US has had to pump in US$2 trillions for a GDP growth of about US$200 billion. Thus, the law of diminishing returns for large money printing is quite advanced as far as the real economy is concerned. More importantly, only about 0.05% of the share of household networth is in gold. So all we need is about another 0.01% of new buying and gold can shoot up by another 50% since the markets are actually quite shallow. There are sufficiently scared millionaires in the world, who don’t know where to put their money. Ten Kilos of gold will easily be hidden in a bank locker.
Sting is in the tail
The latest Investors Intelligence poll for the past week showed the first rise in bullish sentiment since early May - up to 39.8% from 39.3%, while there are only 28.4% bears, down from 29.2% last week.
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