Record Declines in Global
Net Worth Tank Economy

by Joseph Dancy, LSGI Advisors, Inc. | April 3, 2009

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The value of global financial assets including stocks, bonds and currencies probably fell by more than $50 trillion in 2008, equivalent to a year of world gross domestic product, according to an Asian Development Bank report issued last month.

In the U.S. the Federal Reserve reported that households lost $5.1 trillion, or 9 percent, of their wealth in the last quarter of 2008, the most ever in a single quarter in the 57-year history of recordkeeping.

For the full year U.S. household wealth dropped $11.1 trillion, or about 18 percent. Net worth for households and non-profit groups decreased to $51.5 trillion, the lowest level in four years.

Household net worth has fallen in five consecutive quarters for a loss of $12.8 trillion during that period. The decline almost matches the total size of the U.S. economy, which was $14.2 trillion in the last three months of 2008.

What is staggering is that the next largest annual decline in wealth came in 2002, when household net worth fell 3 percent after the collapse of the technology bubble. This decline in wealth, mostly stock market and real estate assets, is much more severe than we have seen in over 50 years (see New York Times chart above).

Illustrating the extent of the damage to wealthy households in 2008 the number of U.S. households with at least $1 million in net worth and those with a net worth of at least $5 million (excluding residence) each dropped 27% from year earlier levels – a record.

The continued decline of the market and real estate values into 2009 has erased trillions more from the country’s collective net worth. While the U.S. Consumer Price Index continues to advance, global asset valuations could be said to be subject to strong ‘deflationary trends’.

The concern we have is that the decline in wealth has been so sudden, extreme, and global that it will lead to a ‘debt deflation’ economic environment. Global and U.S. debt levels, by some measures, are at record levels (see Financial Times chart). The value of the collateral supporting these debt levels has in many cases declined substantially.

In those situations companies and individuals are more concerned about liquidity than profitability, and will sell assets to reduce debt levels regardless of promising business opportunities.

Deflationary conditions, and falling asset values, make cash a highly valued asset that appreciates relative to declining asset classes (see inflation charts above from the Financial Times and New York Times).

In such an environment easy credit terms have little impact as most entities try to avoid debt, which in turns makes any recovery tepid at best. Banks with money to lend will find few takers as firms preserve cash. Employment levels will disappoint. Stock markets in general will not appear to be attractive as global economic growth will be subdued. Preservation of capital will be a primary focus.

Harvard Professor Ken Rogoff has examined dozens of severe financial crisis in the past. Based on historical trends in an interview last month he said he thinks the housing sector in the U.S. is two years away from a bottom.

Rogoff notes that U.S. stocks have declined a bit more than average in a financial crisis – but it will take several more years before we see any recovery in stock prices if history is a guide (see chart from the Dallas Morning News).

Keep in mind the amount of leverage and the global nature of the economic decline make this financial crisis a bit different than those in the past – and potentially more severe in our opinion.

Professor Rogoff confirms the severity of the crisis noting the current crisis is a ‘once in a century event’. He thinks that the economic outlook is much worse in foreign countries as some oversee banks that have questionable debt amounting to three to five times their gross domestic product. In those situations governmental assistance will be unlikely.

Rogoff also thinks that the economic decline will lead to severe political fallout as unemployment rises on a global basis. Some have estimated that up to 50 million individuals will lose their job globally in this recession. When individuals realize how bad the economic situation is, and how long the economy will take to recover, he expects they will get angry with the governments and financial institutions (see BLS chart of U.S. unemployment rate).

In some countries the protests will be orderly, but in others the prospect for violence and social instability will increase substantially.

Latin America, China, and Russia present ‘a very frightening prospect’ in Professor Rogoff’s opinion if economic conditions fail to stabilize (see China export ‘cliff’ chart, courtesy the Los Angeles Times).

In the end Rogoff expects global policy makers to inflate the economy, the least painful method to address the problems from their viewpoint. He expects an inflationary 1970’s type of economic environment as the outcome.

If Rogoff is correct we expect energy and commodity sectors will do well in this environment, just as they performed well in the inflationary 1970’s. But until then, a deflationary environment is not good for these sectors, global economic growth, or the stock market.
Investment Charts & Trends
Following up on investment charts we have examined in previous LSGI Fund Reports we find a number of positive developments. The following charts are of interest:

TIPs Spread - The TIPs spread is the difference between the yield on treasury bills and the yield on Inflation Protected T-bills. The difference between the two is the expected rate of future inflation.

From 2004 through most of 2008 the 5 and 10 year TIPs spreads forecast an inflation rate of roughly 2.5% per year.

With the economic meltdown last fall the TIPs spread predicted a deflationary environment with an annual decline in prices of over 2% at one point – an environment that could be very destructive for the economy and reminiscent of price declines seen in the Great Depression. As of January, 2009, the TIPs spread predicted an inflation rate of zero – better than deflation but worrisome none-the-less.

The TIPs spread currently anticipates an inflation rate of roughly 1% and the trend is upward (toward higher inflationary expectations) - a very positive development. Stocks tend to perform poorly in a deflationary environment. A mildly inflationary environment would be a positive development for equities.

Value Line Appreciation Index – Value Line analysts forecast a three to five year target price for every stock in their 1,700 stock database.

Using this measure we can estimate the long term return from stocks, net of inflation. Longer term this measure has correlated very closely with actual market returns three to five years hence.

The current measure of this index is very robust, one of the highest on record. The Value Line index forecasts a roughly 20.8% annual return for stocks, net of inflation, over the next five years – returns well above average. Last month the index forecast a 17.4% return for stocks – so the indictor has improved over the last month.

TED Spread The TED spread continues to show improvement. The ‘TED spread’ is the yield differential between the front-month 90-day T-Bill and Eurodollar contracts. It is a real money gauge that measures the risk within the global banking system.

Eurodollars are the primary instrument of inter-bank lending—unregulated and uninsured dollars. When the banking or credit markets are stressed money flows into T-Bills while Eurodollar funds become more expensive, hence the divergence or spread in rates.

When this measure drops it is one sign that risks in the banking sector are falling. The TED spread closed the year at 1.35 and is now close to 0.96 – below month ago levels, 3 month ago levels, and 6 month ago levels - a positive sign that the health of the banking sector is slowly improving.

(Charts courtesy Hays Advisory, Bloomberg, and Financial Times)

© 2009 Joseph Dancy

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Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail