Financial Sense Newshour
The BIG Picture Transcription
December 13, 2008
- A Look at the Economic Numbers: What the Numbers are Telling Us
- What Kind of Stimulus
- Supply Destruction vs. Demand Destruction
- Really Scary Predictions
A Look at the Economic Numbers: What the Numbers are Telling Us
JOHN: Well, the Big Picture seems to be getting blurrier and blurrier as we go week after week. At least the picture gets bigger as well, Jim. There’s never a lack of things to talk about lately here. But speaking of blurry, maybe we need to look for the first part of the Big Picture today at what the economic numbers that we always hear reported are not telling us. What they’re telling us is something everybody is talking about; what they’re not telling us are the sort of, what would we call it, the assumptions that no one is hitting upon.
JIM: Well, you know, it’s interesting because we've had a bit of a rally in the stock market as the Obama administration has come in. It’s named its economic team, its national security team. The best thing I think that’s happened for the economy and the market is we don’t see Hank Paulson on TV. Please! Do not put this guy on till the end of the year. So there’s a little bit more of a confidence that there seems to be, okay, there’s a plan that’s being developed instead of the ad hoc remedies that were so characteristic of Paulson and the administration since this crisis really went into high gear beginning with the Lehman bankruptcy. I mean it was every week it was a different program. But if you take a look at that, people are saying, Okay, we've got a plan; and that’s good for the market because the market can sort of get their hands around it and grasp it and say, All right, here’s where we're going, here’s what we're going to do and there seems to be leadership here.
But there’s an awful lot of faith that’s being put on this new president-elect that, okay, he’s going to sweep into office and all these great government programs and stimulus are going to rectify everything. And you know, the one thing that we do know and looking back at the New Deal if you print enough money, create enough stimulus – and most people don’t realize that from 1933 to 1937 was one of the biggest moves we've seen in the economy in terms of growth rates and one of the biggest moves that we've seen in the stock market. So there’s a lot of – have you noticed, John, a lot of references to FDR, a New Deal, or things like that in the press? [2:25]
JOHN: Yeah, but it seems like we're headed down that trail to a large degree. Same program, same proposals as a matter of fact.
JIM: Very much so. And as the economy contracts, and there’s expectations that if you look at the four components that make up GDP – consumer spending, fixed investment, exports and government spending – all right, if consumers are contracting and there’s every bit of evidence that that’s indeed the case, in fact, on the Friday that we're talking about, retail sales in the US fall for the fifth month especially with autos. And so if you have a main component of the economy that is contracting, then estimates that I’ve looked at they’re looking at anywhere from 500 billion to 700 billion in terms of contraction of consumer spending next year in the economy. So if you look at the offset and here’s another headline that was coming out Friday, Pelosi said the stimulus package may be 600 billion. John, the more the economic numbers paint this dreary picture that we're seeing in the economy, whether it’s consumer spending, business fixed investment or the job picture gets worse – and I do think that’s indeed the case; that’s what’s going to happen – the bigger the stimulus. So if consumer spending drops by 700 billion, then you’re talking about an increase in government spending that is going to be equally as large. And that seems to be the case here. But anyway, there’s a big hope on this, so even if the government spends 600 billion or 700 billion, whatever that case is going to be, that just gets us to zero economic growth. So I think that you could see (depending on how the economy unfolds next year) several stimulus programs and several TARP programs. [4:22]
JOHN: It would seem logical to enquire as to how well the Fed’s programs are doing. It’s expanding its balance sheet but the real question is all of this liquidity making its way out into the system somehow?
JIM: Right now it isn't and we talked about this last week when we talked about money velocity. There’s been a giant liquidity injection into the banking system, but the credit remains frozen. And right now, if you take a look at what banks can borrow at, they can borrow at 10 to 12 basis points and then turn around and put that money and deposit it at the Fed at one hundred basis points. So there is a big arbitrage opportunity in terms of what banks can borrow at and what they can earn at the Fed. Now, it’s widely expected that perhaps next week the Fed will cut the federal funds rate by almost 50 basis points; right now in the real market the federal funds rate is trading between one-eighth and one-sixteenth, so clearly the federal funds rate is much lower than what the official rate is. And the other thing that is happening right now, and this shows that there is still stress in the system is that corporate bond spreads continue to widen and credit default swaps are also widening again; so, meaning that there is a perceived risk as the recession plays its way through. That means that’s going to contract cash flow, profits – so there is greater risk of defaults, so therefore credit default swaps are widening again. So we still have a lot of risk in the system, yet that still hasn’t – the credit system is still locked up, still frozen and there’s even talk and you've seen this with some of the new administration officials and also with prominent Democrats, they’re very upset that there have been these injections into the banking system but banks are not lending. Well, you know what, basically what banks are saying is, “Look, based on government law, with the Community Reinvestment Act we made a lot of loans to a lot of people that couldn't afford them. Now you’re saying, ‘We want to see you make these loans,’ but making these loans to people who can’t afford to make their loan payments was what got us into trouble in the first place.” So you’re going to look at some kind of measure in the stimulus program that will either backstop the loans that the government wants banks to make or we've got the Fed now going in and buying mortgage rates and we’ll know later on today how much the Fed bought. It’s estimated that they may be buying between 2 and 5 billion dollars of mortgage-backed bonds. They started last week with about 5 billion in an effort to sort of unlock this system. But we still have problems in the credit industry and not only making credit available but also people that can qualify for this credit. [7:23]
JOHN: I guess we should also look at the unemployment rate because that is a key indicator of how well jobs are doing and that’s what the little guy really cares about. Two million jobs lost so far; claims jumped upwards. And of course, we have those mystery jobs that tend to drop offline when a year later nobody finds any jobs. And these are still also based on – which always makes me suspicious of the birth-death type models rather than actual nose counting out there. But the one thing that you do have some hard numbers on is new unemployment insurance claims that are filed.
JIM: Yeah. I mean the unemployment claims, even the four week rolling average is moving up. You've got a rise in the unemployment rate and what’s even more important and you take a look at the various surveys that are out there that are showing that with corporations that more job layoffs are on their way especially in the financial sector. We saw the big layoffs at Citigroup; 52,000 jobs on Thursday. Bank of America talked about eliminating 30,000 jobs over a three-year period. And so we're playing catch up here, but from the things that I’ve looked at, economists are estimating that the unemployment rate next year jumps from anywhere between 8 on the optimistic side and on the pessimistic side, the unemployment rate can go as high as 9 percent. We're currently at 6.7, so talking about quite a few more layoffs that are coming out as corporations – now, when you can’t get credit, you can’t expand, then what you do is you resort to cost cutting and one of the biggest expenses for many companies are payroll. And so we're seeing further contraction in corporate spending and also the unavailability of credit, so it means the unemployment rate is going to get much worse and could continue to rise especially in the first half of next year; we maybe close to 8 percent. You also have a contraction in consumer credit; HELOC (home equity loans) are falling. So you don’t have the credit availability for consumers to sustain the spending or consumption and that’s being sort of backed up by what we're seeing transpire in retail sales, especially with this number released on Friday that retail sales fall for the fifth month. There was a report earlier that some of the main department stores from Nordstrom’s to Penney’s to some of the big chains could see a fall in sales as much as 10 percent this Christmas season. So we've got a drop in consumption, a drop in consumer credit; we’ve got a real key indicator here is watching the retailers. In fact, watching the Retailer Index and there was a big issue here coming here because this is the season that retailers are supposed to go into the black and there are a number of retail chains that may go out of business depending on what’s happening in the Christmas season. [10:24]
JOHN: You know, what is the importance of the Retailer Index, and how does this tell us what the economy is doing? Obviously it’s an indicator of spending which tells us what people are feeling in their pocket books.
JIM: Sure, because if you’re talking about consumption making up 70 percent of the economy, well, where is that consumption being reflected? It’s being reflected in retail sales. And that’s why I think it’s very important to watch the Retailer Index and this is just a report that I was reading. These are the number of stores that are thinking of closing down: we've got Circuit City which has filed for bankruptcy; how many stores are going to close down nobody knows; Ann Taylor, 117 stores nationwide are to be shuttered; Lane Bryant, Fashion Bug and Catherine’s to close 150 stores nationwide; Eddie Bauer closing 27 stores after January; Cachet will close all stores; Talbots closing down all stores; J.Jill closing; Gap closing 85 stores. Let me just see here - Foot Locker, 140; Wickes Furniture closing down; Levitz closing down; Bombay closing remaining stores; Zales Jewellers closing 82 stores and 105 after January; Whitehall closing all stores. John, this list – let me see, Macy’s to close 9; Linens ‘n Things closing all; Movie Gallery closing all; Pacific Sunwear closing all; Pep Boys closing 33; Nextel and Sprint 133 stores; JC Penney announcing they’re closing a number of stores; Ethan Allen closing 12; Wilson Leather, Sharper Image closing down all stores. KB Stores closing 356 and Lowes to close down some stores. And why that’s important and maybe the next area that’s going to be hit is commercial REITs, especially those that own shopping centers because with all those stores closing down, you’re talking about a lot of retail space that’s going to become available. And so once again, the greater the contraction by consumer spending, you’re probably going to see probably a greater offset being proposed by the government in terms of an economic stimulus package. I mean, originally they were talking 500 billion; this Friday they’re talking 600 billion; and depending on how bad the numbers look in December and January, it may be 700 billion; and John, we're hearing numbers now as high as one trillion. [12:59]
JOHN: The whole issue is very much like when the Fed creates money, if nobody borrows it, no money is created. Here you have an issue of a stimulus and, yeah, you can stimulate all you want, but if people are still going to hold on to their money then that’s not going to do a heck of a lot in the long run because nothing is going to be moving through the economy.
JIM: No. And the other thing too is it’s not just that consumers are paring back spending, they’re going to – it was like in the 2001 recession it was called a business recession. As businesses had to repair their balance sheets, they slashed costs, they slashed spending, they increased savings and businesses got themselves in shape in this decade. Well, the same thing is happening with the consumer now; the consumer is cutting back on borrowing, they’re paying down debt. And so at the same time, business is not encouraged to go out and make fixed investment because they’re saying, Hey, the economy is slowing down and also we're seeing a pullback in exports.
And what I think is rather telling in terms of what’s going to happen in the economy going forward, the Conference Board has a confidence Index of business CEOs, but also the Business Roundtable conducts its own confidence index and they had three major categories, and they’re saying that expectations over the next six months, the majority of expectations, 45 percent of business executives expect business to decline in the next six months, 17 percent expect no change, and 38 percent expected it to go up. Expectations for capital expenditures – only 10 percent of businesses believe that they’ll be increasing their CAPEX spending; 52 percent believe that they will be cutting back on spending over the next six months; 39 percent unchanged. Expectations for employment – only 9 percent of the businesses polled expect to increase hiring; 60 percent expect to decrease hiring, in other words, layoffs; with 32 percent remaining unchanged. There are two expectations that are going on in the market right now; one, the CEOs that run the companies are getting more bearish; at the same time, you have the bears in the stock market that are getting more bullish. So one of those groups are right in terms of what’s going to happen here. [15:30]
JOHN: You know, a core thing that really affects every market and quite frequently gets downplayed as a factor when you’re trying to look at markets logically is the whole psychological factor and all the time when we began to move into this crisis, which we're now what? 24 months into this whole thing, the mantras that came out were ‘no problem’ and then it was ‘well, that problem that wasn’t a problem, we fixed it, don’t worry about it.’ At each point there was a happy face slapped on over the top of it until they couldn't put a happy face on it now. But now we're not admitting I think the depth to which this has gone because the real critical factor here is the loss of public confidence and that is not going to be easily won back. People don’t care what the schmucky-mucks are saying now anymore, they don’t care. They don’t believe them because they told them that it was AOK as we moved into this.
JIM: Yeah, I mean you remember Bernanke’s testimony back earlier in the year that the Fed was saying, Well, based on the interest rate cuts, we expect a stronger second half of the year. Well, that got thrown out the window. And you remember that going as far back as July of this year when Bernanke was testifying that they were still expecting a strong measure of growth going into the latter quarter. You know, they pushed it back, they nudged it a little bit, but they said by the fourth quarter everything should begin to improve based on the interest cuts we've made, the stimulus package, et cetera, et cetera. Well, you notice how they pared that back now; now we admitted that we're in a recession which began in December of last year and I think it’s going to be shocking but I think you’re going to see the economy contract at an annual rate of 4 to 5 percent here in the fourth quarter; maybe 2 to 3 percent or even 4 percent in the first quarter. And that’s what I think has happened here is there has been a loss of confidence and especially the way the Bush administration, the Treasury have handled all these problems, and especially on an ad hoc basis where every single week it was a new program; “Well, we said this last week, well, guess what? That didn’t work and this is what we're doing this week.” And then they tell you this is what they’re doing this week and then the next week it’s something different. And that’s what destroys confidence. It’s like the Anna Schwartz interview in Barron’s. She said you've got to stop having these press conferences, and I think maybe somebody finally got to Paulson because you notice he’s disappeared rightfully so and thankfully so. [17:53]
JOHN: [to Paulson] Would you shut the heck up!
JIM: Stick that guy in a closet. I mean.
JOHN: Put a sock in it. Yeah.
But you’re right. They’ve lost the confidence because of the fact that they were told everything was okay, and it’s not. And you know, the other thing you must admit though, the American public now, we've become used to instant gratification over the last few decades and some of this stuff just isn't instantly going to be cured. And that’s what is driving this even more is people yelling, Fix it, fix it, fix it. And so the impetus for politicians to jump in there and begin pulling levers again and again and again; it doesn't go away either.
JIM: No. And it’s kind of like going to the doctor. The doctor says, Look, you’re overweight, you've got to stop eating junk food, get yourself in shape and start exercising and taking care of yourself. Some people say, Isn’t there a pill I can take. And that’s what we're looking for; we're looking for a government pill that can suddenly make this economy much, much better. And it took us half a century to get here in terms of how bad things have gotten in terms of overconsumption, overspending, lack of saving, lack of investment and you’re not going to fix that overnight. I mean Obama has been playing it pretty smart, he’s basically coming up with a plan but you know what, I think there are unrealistic expectations. It’s like, John, there is no more room for mistakes for this administration – the new one – to make because we made enough of them and we've made enough of them over the last couple of decades. But it’s amazing how the shift in public psychology and even in the financial markets on Wall Street has changed dramatically where when things were going well, when things were booming, everybody was a capitalist. Now that we're going through the bust cycle everybody has become a socialist. And I think how this administration is going to handle this automobile industry, it is really going to very telling in terms of what happens going forward because if they don’t do this and handle it well, it will really tell us where this administration is going to go going forward. And like we said earlier after the elections, the real key here is will Obama govern wisely or will he govern ideologically. And there are going to have to be some tough choices made by this administration and like I said, I don’t know why anybody would want to be president because they inherit one big mess that was created over several decades. And I think people are looking for that economic pill, John, that the government can do this and we're just going to magically transform things instantaneously. I think the expectations are quite high. [20:47]
JOHN: A lot of the CEOs of companies out there are pretty negative. A number of bears out there are actually saying – they’re pretty upbeat on the whole thing and the question is: are we close to a bottom? Because at that point people would feel somewhat secure jumping back, in that, obviously, what they invest isn't going to take the horrible, almost gut-wrenching dive that it did just a little while back there. So how do you tell when you’re at that point?
JIM: You know, the real key and this is an issue that we've been covering on the show; it’s deflation versus inflation. If we're heading for true deflation, much like we did in 1920 to 21 and then again from 1929 to 1933, deflation is destructive for the economy and the markets. And what happens under inflation is you have falling corporate profits, falling corporate cash flows, falling wages, postponed consumption, you have debt defaults – all of this is very destructive for equities in general. So if you take a look at – and this is an anomaly and several people have commented on this is if you take a look at TIPS (which are Treasury Inflation Protected Securities), there is an anomaly here between Treasury yields and TIP yields. And TIP securities are basically forecasting major deflation well into the next decade, and the amazing thing is if the TIP market is correct, investors are pricing a degree of deflation into financial instruments and we're seeing this right now with negative yields on Treasuries or zero yields. On this Friday the yields on six-month Treasury bills, 20 basis points; and only one basis point on one-month and three months. But it will be almost unheard of in the history of our US fiat money system. In other words, if investors are pricing deflation into bonds, they also are pricing deflation into equities, especially by the strong pullback. But if you take a look at these bear markets, deflation would be the biggest risk and any time – and you remember, John, the deflation scare that we had earlier on in the decade, and we said, Balderdash, this isn't deflation, it’s disinflation for a short period of time. And so there are a number of indicators that you can look at in terms of whether this – I call this disinflationary trend is coming to an end, and that’s going to be the key in terms of whether the stock market rebounds. And there are a number of things that you can look at; on the economic front, evidence of low inventories, stabilization of commodity prices and if prices fall as we're seeing on this Friday, producers prices are dropping, rising demand for luxury goods; but I think a precursor to a stock market rally is going to be a rally in corporate bonds because the spreads between Treasuries and corporate bonds keep widening and the rally in corporate bonds will signal a rally for equities. And those are some of the key things to watch is rising corporate bond yields, stabilization of commodity prices and rising prices for TIPS. In other words, as Treasury Protected Securities which rise with inflation, if you start seeing rising prices for them, that will tell you this deflationary trend in the market has ended and therefore you could see a rebound. And this rise in TIPS were very key both in the pullbacks that we saw in 97 and 98 and also in the correction in the markets in 2002, and 2003. I mean looking at my Bloomberg. This just flashed: Ecuador’s president says the country is in default. So, here we are on a Friday and no wonder gold is looking good right now. Ecuador just defaulted on its debt. Folks, we’re doing this in real time here. [24:54]
JOHN: Oh, by the way, Ecuador just cashed out.
JIM: But, hey, a bit of good news: Actor Hugh Jackman will star and host in this year’s Academy Awards.
JOHN: Oh wow.
JIM: Wow. Yeah.
JOHN: I felt shivers on that one.
And as we're sitting here shivering, the Financial Sense Newshour will continue at www.financialsense.com. We’ll be right back.
What Kind of Stimulus
JOHN: Well, I have figured out, Jim, that you can take your TIPS and flips and all of the other indicators you have been looking at. I think the core economic indicator of whether or not I’ll personally be in a depression is if Starbucks shuts down and I can’t go to my Starbuck here. I will be in such a depression that you have never seen before. That’s my key economic indicator.
But we're talking about stimuli here. And the more I look at some of the stimuli that they’re talking about putting into the markets or are doing right now, this is really hauntingly looking like FDR’s New Deal. It really does. It’s beginning to have the look and the smell, like you were saying on TV they’re talking about it, but if you go back and look at what FDR and Hoover did, we're pretty much doing the same thing. Maybe a different name or a different package employed in a different way. But we're getting there. And last week we also talked about quantitative easing on the part of the Fed, but then if nobody is lending, or for that matter, nobody is borrowing, then fiscal policy kicks in at this point. So when we talk about stimulus, what are we really talking about?
JIM: The fact is, what we're trying, John, is the very same remedies that got us into this problem in the first place. I mean the perfect solution would be for people to start to increase saving, increase our investment, cut consumption, cut government spending and restructure the economy. That would be the ideal solution here. But you’re obviously not going to hear that coming from Washington. No politician is going to say they’re going to cut government spending. They’re talking about programs to increase consumption and prevent bankruptcy, but, you know, the very thing that we need to correct the market when you have too much housing available, the way you correct that is, well, number one, stop producing housing so you don’t add the inventory; number two, let the market clear these bankruptcies. In other words, housing prices have to fall to a level they become affordable again and that’s how you get a natural correction. But obviously, you know, it was debt consumption that got us in this mess, but we're doing everything to increase consumption. You know, when you listen to the politicians, no politician is going to say we're going to cut back, every politician that I’ve seen is – you know, nobody has any stomach for pain. You know, it’s like going to your doctor, again, I use the medical analogy. You come in, you’ve got high blood pressure, arteries are clogged and the doctor says, Look, you've got to change your diet, you've got to change your lifestyle, be less stressed and you've got to start an exercise program. Most people would say: Isn’t there a pill I can take, you know, so I don’t have to do this? And that’s what happens. In a political system that we have right now, there is no stomach for pain and like I said, during the booms we're all capitalists; in the bust we become socialists. Look at the number of industries that are lining up at the trough from the financial industry to the auto industry; and I’m sure some time in the next couple of years it’s going to be the airline industry. [28:57]
JOHN: Given the way things are rolling right now, it looks like the Fed is dead set on a course of inflation, so let’s assume that they do continue this course of inflation which ultimately devalues everybody’s money and we pump all this so-called stimulus in, supposing it doesn't work –and there’s a high probability of that – what’s left in the game?
JIM: Well, if you’re going to inflate, you are going to use Keynesian government spending then the real key is what are you going to do with the money that you create. And it looks like we're going to go down this route because the proper thing to do, as we talked about, is to increase savings, investment, cut consumption, and start producing goods. We’re not going to do that. So it really boils down to the nature of the stimulus: are we going to build 20th Century type stimulus programs and build bridges to nowhere; or are we going to modernize our infrastructure for a 21st Century economy? What we don’t want to see in a stimulus program is all these pork programs that we got with the TARP program. Remember, the past TARP – I forget how many, it was 150 –or I forget what the number was – billion dollars worth of pork programs that they put in. You know, every congressmen: Well, to get my vote, I want this for my district. And that’s not what you need. You need a system that’s going to modernize the economy.
And one of the hopeful things that I’ve heard from the Obama administration, they’re talking about a mass transit system and it’s rather interesting in that people are going back to mass transit; more people are riding buses, more people taking rail and using the transfer system versus cars; rebuilding and modernizing our railroad system for transportation and also for travel, much like what Europe did during the energy crisis of the 70s. Electrification of the transportation system, whether it’s buses, whether it’s cars, we go to electrical hybrids that we plug in. There are a number of cars coming out, in fact I think BMW just announced their Mini Cooper, they have an electric car, a Mini Cooper that’s coming that’s going to get I think 150 miles on a charge with a top speed of 95. Okay, if we go to electrification of the transportation system, then obviously you’re going to need power plants and what if we also do the Pickens’ plan where, you know, we go and start converting natural gas to liquid fuels or fuels for cars and then taking natural gas out of the power system and substituting solar and wind so that we have a bridge for fuels because our transportation system – and this is what most people don’t understand, it’s a liquid fuel problem. The boats that bring goods to harbors here run on diesel fuel, the trains that transport it to hub centers run on diesel fuel, the trucks that bring things to stores run on diesel fuel, the car that you drive to get to work or do your honey-dos and chores on a weekend, run on gasoline, and if you travel by airplane that’s jet fuel. This is a liquid fuel issue. So the real key here is what kind of stimulus program are they going to do. And are they going to be smart enough to, in other words, not look at the old infrastructure but look at a modern infrastructure: a mass transit system, transportation system that we know is efficient to haul goods by rail than it is by trucks. [32:86]
JOHN: By the way, some of those rail can convert over to electricity now. In other words, if we want to talk about less polluting – if you generate your electricity by less polluting sources and these diesel engines aren’t belching out all of the exhaust and that takes the emphasis off of liquid fuels, that’s the one place you could do it right there. I mean, obviously, there is an infrastructure that has to be built, but in Europe they’ve already done some of that. So I mean we need to play catch up and really move in this direction where we take wind and solar and develop that because we know it works, we can bring that into the electrical grid system and provide power and then maybe move more natural gas towards liquid fuels – the development of even ammonia into liquid fuels, as we heard in the second hour when we were talking to Matt Simmons.
The other thing, and the real exciting thing that I have seen come from this administration is our whole energy infrastructure is in decay. You know, our energy infrastructure is built on steel, steel rusts, so you’re talking about redevelopment of resources, which could take trillon of dollars, but at least you’re going to get some kind of bang for the buck. So it could be the best investment that this country makes is a 21st Century infrastructure rather than a 20th Century infrastructure where you get mainly pork barrel projects and even some kind of system – even in our defense system, even revitalizing and changing the military. I mean the amount of money that this country spends to build an aircraft carrier battle group, which is increasingly becoming the weapon of the last war, they’re increasingly becoming more vulnerable, they’re more expensive to run. Even building or redoing the nation’s defense system and I’ve heard talk about that.
So it’s probably going to take, unfortunately, some kind of combination of government and markets to rebuild our energy system, and unfortunately, we don’t have the time. But a stimulus package that redoes the transportation system, redoes the power grid, rebuilds our water systems, these are the important things that we need to do. And there’s also even talk, I hope, of even redoing our education system which is pathetic when compared to the rest of the world. And I think you’re going to see an emphasis in the future of more online education rather than brick-and-mortar education. And I mentioned the military – we talked about alternative energy. Think what this could do to revitalize the automobile industry in the same way that building the highway system after World War II – think of what that did for our economy. So, what I hope we don’t see is if we're going to inflate –which is what we're doing –and if we're going to stimulate with fiscal spending, is we design programs to spend on consumption and pork areas, you know, then when that all plays out we're going to end up no better than becoming a banana republic. So if you’re going to inflate, at least get something other than trinkets that you’ll have to show for it when the inflation plays through. [35:53]
JOHN: Financial Sense Newshour continues at www.financialsense.com.
Supply Destruction vs. Demand Destruction
JOHN: Prices of oil have come down at levels that I don’t think a lot of us expected, and some people now because of what they are maintaining as the result of demand destruction, meaning the economy is going down therefore people aren’t spending or traveling as much, and commodities are being delivered so therefore demand is down and that is what is accounting for the reduction in oil prices. They’re even calling for like 20 to 30 dollars a barrel. If you listen to the interview that we did earlier with Hirsch and Simmons, the real part of the picture that is missing in this whole thing, Jim, is supply destruction. And you know, we keep talking about – people who talk about like, say, for example, abiotic oil and all of these other issues and people do not understand: this is not just an issue of the total quantity oil that is out there. If the Gulf of Mexico were to turn into a vat of oil tomorrow, we couldn't anything with it because our infrastructure is shot. That’s why. It’s not handling it. So it’s really a supply issue and that is the big picture that people are missing that is going to bite us here in very short order.
JIM: You know, you’re right, John, there are two factors that are the key to energy and it’s very simple – that’s the amazing thing about it – one, is the depletion rate, in other words, all wells we know have a finite life to them. And the depletion rate, once an oil well, like a bell-shaped curve, once it hits peak production, it starts to decline. And that’s the depletion rate. And we've had a series of reports over the last couple of years where now that we have more detail – and especially the IEA report that came out in November, which we referred to in the roundtable discussion in the second hour – originally in August, they said in their mid-year outlook based on what we're seeing they increased the depletion rate from 4 percent to 5 percent. Finally, in their 2008 outlook which they published in November, they came out after studying a hundred of the world’s largest oil fields that account for 75 percent of the world’s oil production. The depletion rate is 9 percent, so you’re losing 9 percent of your production each year which means you have to go out and replace that just to stay even. So, point number one, is the depletion rate.
And number two is discoveries. And everybody knows you can’t keep producing something and not replace it. And we have not been replacing what we consume for close to two decades now. I think it was 1985 was the last year that we actually found enough oil to replace what it is that we consumed.
And if you look at the IEA report, one of the things that I found astonishing that the press hasn’t picked up on this; they had a table of the world’s 20 largest oil fields that account for 25 percent of the world’s production. John, they are all in decline. And what is even more remarkable in the November report, when the IEA initially released their press release of their upcoming report, instead of focusing on the depletion rate being 9.1 percent, and what the IEA said which was is if you look at what the IEA report, the opening sentence from their executive summary and Matt referred to this, I’m quoting directly from this report: The world’s energy system is at a crossroads. Current global trends in energy supply and consumption are patently unsustainable environmentally, economically and socially. And the last words that they put to their executive summary, time is running out and the time to act is now. And what is absolutely amazing is when this report came out, the only thing the media focused on at that particular point in time was the fact that they had reduced their demand for energy by, I think, like 100,000 barrels or a couple of hundred thousand barrels and they had reduced the increase they expected for next year to only, I think, like a half a percent consumption because of world contraction in economic growth. And you know what, it's absolutely amazing that this report came out and nobody paid attention to it. [40:54]
JOHN: One of the blocks that you have in the public mind-set right now is that even we say, say for example, energy production has peaked, even when the prices ran up pretty high –and now they've come down again – they are theoretically (aside from a certain amount of interruption going on in the southeast here) basically people haven't had trouble getting gas. We haven't seen the signs that we saw in the seventies, “out of gas,” etc, so people find that a little hard to swallow.
JIM: What they forget is you take a look at the last 10 years and especially as supply has struggled to keep up, we've gone to gas to liquids, coal to liquids and biofuels and that's made up the difference. So, John, you're right. Prices have gone up because we've had bottlenecks in the sector whether it was diesel this year because of increased imports from China, especially when they began to run low on diesel ahead of the Olympics and respectively after the earthquakes, and so we have these little blips that occur in hurricane areas where people in Atlanta couldn't get gasoline for almost four weeks. And so we've had these little pockets that have occurred throughout the United States, but, you know, one thing that we've had up until this time is synchronized economic growth. Now we're seeing synchronized decline. In other words, the major developed economies are in recession and even the emerging economies are slowing down in terms of their growth rate and so everybody is focusing on demand destruction. The question is: has demand fallen enough that would justify the price falling from 147 to 40? Now, some might say the price of 147 was artificial. No, it wasn't. We had bottle necks in the refinery system, we had bottlenecks in the delivery system and there have been a number of institutions that have looked at this, both the task force that was put together by the government to look in in terms of commodity speculation and the IEA report looked at this and they said we have these various bottle necks. And that's what can happen. You get a hurricane, you get a disruption of a pipeline breaks down. I can remember a couple of years ago, a pipeline from Texas to Arizona broke down and they had shortages in Phoenix of gasoline. So the problem that we have is the market is so short term in its thought process and they are looking at market prices strictly to draw conclusions as if these market prices were accurate. And this gets back to the efficient market theory. If the efficient market theory was indeed true, we would never have had the huge fall off in stock prices that we saw in 2000 to 2002 or what we've seen this year. And the same thing holds to market pricing of commodities. I mean just to give you an example, if you go back as far as two months ago, the Financial Times, the Wall Street Journal were running articles about “the world is having difficulty keeping up supply.” This is going to be a major problem going forward. Now, we've got just the opposite. Well, we have too much supply, this is the end of the bull market in energy, it's the end of the bull market in commodities, everything is hunky-dory and there is going to be all of this excess supply, and John, it's like, did the world change in two months? I don't think so. [44:21]
JOHN: Again, we come back to the short-lived monitoring that the public and even the markets tend to have. Remember it was just 24 months ago the economy was not on the radar of the presidential candidates. Everything that’s been happening was not on people's radar and it pops on very quickly and so people react very quickly and make quick decisions which is why we are where we are; nobody is thinking long term.
JIM: No. And if you take a look at what they are not focusing on is supply destruction is occurring at a much faster rate than demand destruction. I mean if you take a look at Canadian tar sands, they cannot make money producing oil at 40 bucks a barrel. You had PetroCanada halting work on 140,000 barrel per day project which was supposed to come online in 2011. Construction costs have soared in the energy and especially in the tar sands by almost 50%. From Canada to Russia to Saudi Arabia to Asia, oil companies –both international oil companies and national oil companies – are slashing CAPEX spending. Morgan Stanley just issued a report: 17 major energy projects are either being delayed right now or cancelled and this has occurred since October. Across the board you're seeing spending cuts by your major oil companies and they are estimating next year CAPEX spending can drop anywhere from 10 to 20%; nearly every oil sand project is now on hold; expansion in Kazakhstan has been halted. Even a new refinery that they were going to build in Saudi Arabia, the Yanbu refinery, has now been delayed. And if you look at the headlines, and as Matt talked about, just read chapters 10 through 13, the IEA is sounding the alarm bells in the most subtle way, as Matt talked about in the last hour, that there is a fire in the theater. But right now, the market is focused on short term demand reductions and they are not focusing on demand destruction and depletion. And if you take a look at major discoveries have been fewer and smaller. New production, where is it coming from, tar sands, tar sands being shut down; OPEC is talking about additional supply cuts; deep water is shut down because they can't produce more; Barnett Shale companies are cutting their CAPEX. If you take a look at the drill count, it has fallen by or rig count has fallen by almost 30%. So supply has fallen much faster than demand. If you look at a recent article in BusinessWeek, they talk about SUV sales have picked up; or people that have 12 and 13, 15 mile per hour SUVs are trading them in for SUVs that get 18 miles per gallon. Export companies, if you read the IEA report, are consuming more and more of what it is that they produce, and so there is an anomaly here and people are only focusing on one side of the equation, and I think that's going to lead to a problem. [47:29]
JOHN: You can see this collision approaching right now because a lot of governments around the world, China, the US, others are spending on their infrastructure assuming that we're going to expand that to allow economic growth, but at the very same time the complicating factor here is the fact that supply is dwindling and it doesn't make a difference how much you spend on the infrastructure because that's going to be the core factor here.
JIM: Yeah. So at the same time that governments are trying to increase demand, the industry because of pricing is curtailing supply, and that's why I, I think, I don't know, John, if it's in the second half of next year at what point this train wreck is going to arrive, but we're heading for the perfect energy storm based on rising demand, falling supply, contracting credit. And this is affecting the energy industry, especially a lot of the independents and 4) government inaction. And as we all know whether – even if you made a new discovery like the Alaskan Slope or the North Sea, it took 10 years to bring those oil fields online, so even if we made a major discovery tomorrow or if we made one a couple of years ago, it may take 8 to 10 years before you start bringing that new supply online. That's why last year in the IEA report it talked about a crisis window developing after 2010 to 2012. And I can see that crisis window accelerating because you add up all of the monetary stimulus that the Fed is using now, the Fed's balance sheet may be three trillion by the end of the year. There is even talk next year it could rise to as high as 5 trillion. You're talking about massive stimulus. And so eventually, you throw enough money printing, throw enough stimulus, you get some kind of economic recovery at the time the world's economies begin to recover again and grow at a faster rate, we're going to be demanding more energy at a time that supply could be dropping dramatically as a result of these lower prices because everybody in the industry, you talk to them, they are acting like, oh boy, we've been through this rodeo before, the rig count is down 30%, projects are being delayed, they are being scuttled and that's why I think we could be heading for a real problem here because people are only focusing on one side of the issue. [49:54]
JOHN: What kind of time limit do you think we have on this too, Jim, before these converge because we're talking about the new presidency of Barack Obama, he's going to try to deal with economic issues. This thing will come out like left field type of an issue and suddenly clobber unless they are looking. I'm not sure they are.
JIM: It's really going to depend on how fast – We could see economic growth synchronized. I mean China is going to be spending 600 billion developing its own internal demand being less reliant on, let's say, demand in the US, and Europe is doing the same, the US is doing the same. You'll be seeing other countries from – I mean look at the rate-slashing that has occurred just in the last month all around the globe from Europe to New Zealand to Australia to Canada to the United States. Next week it’s widely expected the Fed will cut interest rates another half a point and we'll know later on today how much the Fed bought in the mortgage market. So I would say probably in a three to six-month period, we should begin to see prices begin to firm up and even those that are expecting the economy to contract even further next year, especially in the first quarter but they are saying that, you know, the slow down in the economy begins to taper off as we get into the second and third quarter depending on how much stimulus and how much monetary stimulation that we're going to see coming both from the Fed and also from the government. [51:24]
JOHN: And you're listening to the Financial Sense Newshour at www.financialsense.com.
Hello, I'm Dan Henninger for the Wall Street Journal. Just as Washington prepares to rescue Detroit, the Wall Street Journal has learned that the US government is planning to bail out Christmas. The Treasury Department believes that without an immediate capital injection Santa Claus will fail before December 24th. In a statement to be released later this evening, Secretary of the Treasury Hank Paulson will announce, in his view, Santa Claus is ‘too big to fail.’ We have learned that Secretary Paulson personally made a trip to the North Pole last weekend to discuss the situation with Santa. Piecing together the story it appears that some of Santa's elves became involved in a securitization scheme involving an instrument known as Christmas list swaps. The market beneath these so called Christmas list swaps turned sour and Santa faces imminent collapse taking Christmas with him.
The Paulson plan to bail out Christmas has encountered resistance on Capitol Hill. House speaker Nancy Pelosi has informed Mr. Paulson that no money will be forthcoming for Christmas unless Santa agrees, in Speaker Pelosi's words, to ‘go green.’ While many believe Christmas is already green, Speaker Pelosi has said that environmental groups have complained for years about Santa's eight tiny reindeer and that further Mr. Claus will be asked to appear this Tuesday before Congressman Barney Frank's committee with a plan to reduce his sleigh's carbon footprint. For now, the two sides remain at an impasse. We have made repeated calls for comment to Santa at the famed toy maker's North Pole workshop, but those calls have not been returned. We promise updates as the Christmas bail out story unfolds. For now this is Dan Henninger for the Wall Street Journal. [53:20]
Really Scary Predictions
JOHN: We thought you'd enjoy that today. That was Daniel Henninger on the Wall Street Journal website: Is Christmas too big to fail. It just seems to be getting into the spirit of the season here. It was a dark and stormy night and someone was asked to make financial predictions about the coming year. It's that time of year, Jim, when we start to look toward the next year and Fortune magazine has published the predictions of eight different people, so we're going to cite some of these and it's a little late for Halloween, but what the heck. Let's start with Nouriel Roubini who has been Dr. Doom out there in the markets.
JIM: If you're not familiar with Nouriel Roubini, he's an NYU economics professor who has been talking a lot about much of this credit crisis that has unfolded over the last couple of years. His predictions are for next year the Dow drops to 4000, we see food shortages, a bubble in treasury notes. And what he's going on to say is that the recession that we're going through now is unlike anything we've experienced dollars in the last 50 years. And this huge credit build up and leverage that we built up in the system is reversing right now in a very massive way and so we're heading into a global recession and it's becoming worse. And things are going to be awful for every day people, according to Roubini. US GDP is going to be negative all of the way through the end of 2009, so if that's the case, John, this will be the longest lasting recession that we've seen since the Great Depression. Now, he sees a recovery in 2010 and 2011, but it's going to be a weak one. In other words, the economy rebounds, but we only get economic growth rates of 1 to 1 ½%. He's also predicting that home prices are going to fall another 15% and they won't bottom out until 2010. The stock market will go lower, commodities will fall and stay away from anything associated with credit and high yield. So that was Nouriel Roubini, the first of these eight experts. [55:37]
JOHN: You notice that Roubini in his prediction, Jim, is looking at the recovery 2010, 2011, he says if there is a recovery, but again, pursuant to what we just discussed in the last segment is they are looking at the credit issue as far as the crisis. What's rising is the energy dragon and that's going to – it's like somebody making a get-away and you get broadsided by this other issue that you didn’t see coming. Very few people are looking at the overall picture here.
JIM: No. They’re not seeing the rise in this storm that's heading for the energy sector at the time that governments around the globe are trying to stimulate the economy and get the economy on track to grow again. Well, that's going to need energy. At the same time, energy supply is being curtailed and falling off a cliff, and so that's something that neither are talking about. [56:27]
JOHN: The next person who has made a prediction here that was carried in the Fortune magazine article is Bill Gross. Basically his wasn't as much a prediction as saying, he did make one prediction that right now Wall Street and Main Street are both fearful that the recession may be replaced by a near depression and what he determines “the outcome is going to be determined by the Obama administration’s ability to rejuvenate capitalism’s animal spirits by substituting the benevolent fist of government for the now invisible hand of Adam Smith,” and that's a polite way of saying get the government out of the way and let the market forces get back in here and go to work. And the government is going to actually be in the way doing this rather than out of the way. Federal spending and guarantees, he says, in the trillions of dollars will be required to fill the gap created by the deleveraging of private balance sheets; and then he said also in turn lenders and investors must begin to assume risk as opposed to stuffing money in modern day investment mattresses. Probably a core idea, “the process is going to have to take time.” And he says 12 months of the Obama nation may not be sufficient to heal the damage of a half century of excessive leverage. So he has a sober evaluation there, it's going to take time to let this heal.
JIM: And his prediction that eventually people will move out on the risk scale is based on the bubble that he sees in the bond market where you have treasury yields that are basically zero. I mean a six month treasury bill 20 basis points, one year treasury billion less than ½%, a two year treasury note at ¾%, and a five year treasury note at 1%, so there is virtually no return to these assets. Now, the next guy that they interviewed was Robert Shiller, he is a Yale professor and co-founder of Macro Markets and he said that we don't currently have anything near the level of unemployment that we had in the 1930s. He said otherwise there are many similarities between today's environment and the Great Depression with things happening today that we haven't seen since then. First of all, there is the magnitude that the stock market moves up and down. You know, most of the 4% moves that we've seen in the stock market's history have occurred in the last two months. He said the only other comparable event was one in the 1920s when real stock prices more than tripled in 1924 to 29 and then fell 80%. But he said, “I'm optimistic that we'll do better this time, but I'm worried that we're vulnerable. One of the lessons from the Depression is that things can smolder for a long time. What I'm worried about right now is that our confidence has been hurt and that's difficult to restore, no matter what we do, we're trying to deal with a psychological phenomenon.” So he's talking about something we had talked about in one of the other segments which is about restoration of confidence because markets run on confidence. [59:29]
JOHN: Sheila Bair was the next one up in the article here. Hers weren't so much predictions, as what really needs to happen. She analyzes what went really wrong as far as how we got where we are. There seems to be a lot of agreement here by the way among the people who wrote these various little blurbs. She's an advocate of the basics when it come to investing: do your homework, invest in securities you understand and then hold on. She said we are going to dig out of that. And when we do, she hopes we're back to basic society where banks and other lending institutions promote real growth and long term value. That's why she's saying we have to do our homework and avoid the nonsense that got us where we are today. Anyway, the next one is Jim Rogers. Jim.
JIM: Jim is probably one of my favorites here, and he starts out, he said we're in a period of forced liquidation which has happened only eight or nine times in the last 150 years. It's interesting this time that there is forced selling of almost everything with no regard for facts or fundamentals – something that we've been talking about here on the program. He said, historically, the way you make money in times like this is that you find things where the fundamentals are unimpaired. And he goes on and he says “the fundamentals of GM are impaired, the fundamentals of Citigroup are impaired. Virtually, the only asset class I know where the fundamentals are not impaired, in fact where they are actually improving, is commodities.” And he goes on. “Farmers cannot get a loan to buy fertilizer right now. Nobody is going to get a loan to open a zinc or lead mine. In fact, they are shutting them down. Meanwhile, every day the supply of commodities shrinks more and more. Nobody can invest in productive capacity, even if they want to. You're going to see a gigantic shortages developing over the next few years. The inventories of food worldwide are already at the lowest level they've been in 50 years.” This goes back to something Nouriel Roubini said about food shortages, which I could see unfolding. Rogers goes on, “this may turn into the Great Depression too but if and when we come out of this, commodities are going to lead the way.” What I've been buying recently is agricultural commodities. I've been buying Chinese stocks and for the first time I'm investing in Taiwan. I've covered most of my short position in US stock and now I'm shorting US government bonds.
And he agrees with Bill Gross who said that the Treasury market is the next bubble to burst and Rogers goes on here and he goes there are going to be gigantic amounts of bonds coming to the market and inflation will be coming back. He says US stocks still aren't attractive and the key is to buy things whose fundamentals are unimpaired and that's once again why he likes commodities and this gets back to energy, food and water and the basic necessities of life. [1:02:27]
JOHN: Well, the next on the docket is John Train and he's saying he presumes that although we're in a severe recession, it will not decompose into a full scale recession. What he is comfortable with is owning shares in businesses that do well in all circumstances like Johnson & Johnson for example. He says they rarely fly out of the park but provide long steady gains that will get you where you want to go. They usually have huge cash hoards such as Cisco, Apple, Microsoft, Berkshire Hathaway and their war chests exceed 20 billion dollars. In the present environment, he favors companies that can prosper in the lean years ahead, which is, by the way, Jim, what you've been saying is invest in things that do well in this type of environment and he's saying, so not Saks but rather WalMart, not Neiman Marcus but Dollar General etc etc. And when should you buy? He says you should buy at what he calls the time of deepest gloom if you can spot it. [1:03:21]
JIM: And now, a gal by the name of Meredith Whitney, she is an analyst with Oppenheimer that got this credit market dead right, and she said “what the federal government has done so far with TARP, bailing out of Citigroup has stemmed the bleeding, but what it hasn't done is fundamentally alter the landscape. Yes, there has been a tremendous amount of capital thrown into the system, but my concern is it's just going to plug the holes. It's not going to create new liquidity which is what the system actually needs.” And she's predicting and I agree with her 100 percent, and we've already heard word of this, you’ve heard about TARP I, she says you're going to see tarp 2.0, 3.0, 4.0, 5.0 and 6.0 by the time this is all done and she goes, what happens in 2009, frankly, is hard for me to predict what is going to happen next week, never mind next year. What I will say is that I expect all of these banks to be back to the market looking for more capital. We also have had wholesale restructuring, we're going to see wholesale restructuring of our banking system probably towards the end of 2009, which could even imply nationalization. There will be banks getting smaller, banks going away towards the end of the year, banks consolidating. She says overall, I think the economy will be worse than people expect, the biggest issue will be consumer spending. And just to give an idea of the amount of losses, this is a little bit week delayed, but as of now, the world has written off $988 billion worldwide, roughly 670 billion coming in the US. We have raised in the capital markets 911 billion, 948 billion of that coming in the US. And as we have talked on earlier programs, by the time this is all done, there will properly be close to two trillion dollars in capital losses, so right now we're probably at the halfway mark. [1:05:20]
JOHN: Well, Wilbur Ross admits that we're clearly in a serious recession and more aggressive action is going to be needed to turn things around. He says, “The federal government initially underestimated the scale of the mortgage and housing crisis and then finally panicked into an ever changing series of ad hoc measures that dealt with just some of the effects of the original crisis. He says “However, the economy will not stabilize until mortgages are adjusted down to the value of homes with affordable payment schedules and until new mortgages become available across the home price spectrum.” And he said, “Until then, the poverty effect of falling house prices and unemployment moving up towards 7% will hold that consumer spending back.” He’s talking about incentivizing lenders to restructure mortgages by guaranteeing half of the reduced principal amount and sharing among the government homeowners and lenders any subsequent appreciation. He says Detroit needs government support in order to implement independently verified concessions from all of the stakeholders and not just labor, which are sufficiently large enough to permit profitable operations. I think this is the key thing about this whole bail out. If we just bail out for another six months or something and nothing really changes. Remember, we've seen reports now, Jim, of people who got bailed out on their mortgages and they are having to be bailed out again. Nothing really changed. We just prolonged the agony. [1:06:44]
JIM: Yeah. I think, what was it, 53% of them that got their mortgages restructured defaulted once again.
JOHN: Right. Exactly. So basically he's saying we could end the recession by early 2010 if President Obama promptly and decisively revolves these problems and here is the big thing, restores public confidence. But again, Jim, they are looking at the economic issue, they are not looking at the green dragon of energy coming alongside of it, and I think that's what making this much more of a perfect storm than they are anticipating. It will be interesting to see them all talking about this 24 months from now when they go: where did that come from?
JIM: Remember that little thing we were talking about that you paid no attention to? That's where it was.
JOHN: And coming up next, we'll be taking your phone calls on the Q-lines as the Financial Sense News Hour continues at www.financialsense.com. [1:07:31]