The "Y-shaped" downturn - A Greater Depression?
A more severe crisis is already "Baked in the Cake"
by Michael Hampton, AKA Dr.Bubb | February 10, 2010Print
I have been asked by many on my Global Edge Investors Website to explain why I am "so surprisingly bearish" about the prospects for 2010 and beyond.
My opinion is that a Depression is already "baked in the cake", and we will soon be "eating the cooking".
The best we can hope for is to delay the inevitable, and/or to make a very severe recession or depression as quick and painless as possible. Recent actions by political leadership and monetary authorities in the US and the UK have delayed the most severe part of the recession. But the cost has been high, and the eventual downturn may be worse than if they had taken different actions or simply done nothing.
: A "Y-shaped" downturn?
There is much talk of a possible "W" shaped, or double-dip recession. What is being little discussed is what I call a "Y" shaped downturn, where the second fall is so severe that it dwarfs the first dip, so that the second leg down comes to a lower level. When the two economic falls are put together the resulting pattern may look more like a small-case Y than a W. And the upturn may be slow in coming, with no quick recovery coming out of the second slide. The overall result may be worse than the 1930's, a Greater depression, rather than merely a repeat of what we saw eight decades ago.
George Soros recently spoke about a recovery that looks like an "inverted square root sign." In other words, growth stalls, and the economy goes sideways for some years. "We may even see another dip, if stimulus is not maintained," he said. Frankly, this confuses me. The economy has been hampered by wasteful investments, and too much debt. The so-called "stimulus" plans add debt, and encourage more low-return or no-return investments. I do not see how these programs help the economy.
Many of the best known economists are already talking about a recovery which they say is underway. Indeed, the US has just reported Q4.2009 economic growth in excess of 5%. On my own GEI website, I have been accused by one poster of "drifting off into neverland talking about what to do after a financial holocaust which has not happened yet."
Why am I expecting a new, more severe downturn?
My expectation is that the next economic downturn will come quickly starting about mid-year, and those who fail to prepare will be blindsided, and suffer a very large loss of wealth. The time to make preparations is when confidence is high, and the cost of preparations is low, because fear has receeded. After a strong nine months rally in global stocks (which by the way, I forecast back in March as the market was turning up), there is now widespread denial of problems, and huge complacency. Preparations can be made now, and hedges put in place, at a low and bearable cost.
The basic problem that I see is two-fold: Too much debt, and widespread malinvestments. There is no longer a reasonable balance between the funds needed to service the debts and the cash flows generated by investments. The severity of the problem is masked, but only temporarily, by ultra-low interest rates. Even with the low rates, debts are continuing to default, and the number of troubled loans is increasing. When the inevitable rise in rates comes without a big rebound in earnings and cash flow, debt problems will multiply, and the financial sector will seize up with another severe credit crisis.
Here is an outline of my overall argument, before I will take you through some of the evidence:
+ A second leg down in US house prices lies dead ahead, with even larger fall is possible in the UK
+ Commerical property is headed towards a debacle in both the US & the UK
+ A second banking crisis seems inevitable (as the above problems manifest themselves)
+ Sovereign and US state credit ratings have come into question, and defaults are likely in 2010
+ Days of low inflation from the first downturn are ending (as low inflation from early 2009 gets lost in history)
+ Rates are bound to go higher, as savings rich countries attempt to flee the increasing credit problems
+ Iceland, and its stagflation are a model for the future in many countries, including the US & the UK
+ Weaker currencies are not really a cure, since they will bring much cost-push inflation in food & energy
+ The longer term cure only begins after we face reality, make writedowns, and restructure the economy
+ So-called stimulus programs merely add debt, and low-return investments to an economy which needs better
More specific remedies:
+ New types of investment are required, western consumer economies must be restructured towards becoming producers again with more internal savings. That is a slow process, especially when limited capital is being steered towards wasteful areas, propping up old malinvestments in a an obsolete consumer-driven economy, rather than aiming to build a new and more efficient post-consumer economy with dramatically less reliance on expensive imported energy
+ As savings are rebuilt in Western countries, growth will be slower, and probably bring negative growth for many years.
+ Those who are unprepared and unhedged are likely to suffer a huge loss in their wealth
HOW THE CRISIS MAY PLAY OUT*
The big drop in oil and commodity prices and massive deleveraging beginning in the second half of 2008, brought several months of negative inflation numbers. Most observers focus on 12 month's CPI inflation, and so these price drops gave central banks the cover that they needed to sharply reduce interest rates in late 2008 and early 2009. Starting with the UK, we saw massive quantitative easing (QE) programs in many Western countries, which brought rates down to levels which enabled falling asset prices to stabilise and rebound.
The Temporary drop in Inflation is behind us
In virtually all countries, the months with the lowest CPI in most countries were in Q4-2008 and Q1-2009. Those low inflation months are falling out of the 12 months window as we move into 2010. In Q2-2010 we will find that many countries will be soon be reporting "higher than expected" inflation. If people looked at the data closely, they would not be surprised to see 12 months inflation rates rising in the months to come, but many do not bother to check the details. But even those that do investigate and anticipate rising inflation, will have to admit that inflation has pushed up above normal "target" levels, which for most Western countries is set at 2% or so.
The rising inflation is unlikely to be accompanied by healthy and sustainable growth. There will be growth in most countries, but much of this will be merely the result of debt-fueled government stimulus spending. Plus there will be some temporary factors like 1 million temporary jobs being added in the US to assist with the 2010 census. Businesses have be reluctant to spend and rehire, because they do not trust economic growth which is so heavily reliant of the false elixir of govern stimulus.
The Fed and other Central banks will soon be caught "between a rock and a hard place," seeing that it is prudent to raise rates, but not wanting to do so for fear of pushing unacceptable unemployment levels even higher. The UK and countries in Europe may feel stagflation acutely, since productivity in those countries has not improved as sharply as it has in the US. But if they keep interest rates low, their currencies are likely to get hit by selling. That may help exports to some degree, but it will come at the cost of more cost-push inflation from higher import prices. Europe will also feel the stresses from deterioration of sovereign credit rates, as countries like Greece, Spain, and Ireland are pushed into defaults or painful bailouts. The US will face similar challenges from the continuing rapid deterioration of the financial condition of most US states, with California a particular concern.
US & UK property prices - the Rallies will soon stall
(Source: US Case-Shiller Index-20 Cities x1,300; and UK: Average of Halifax & Nationwide prices, NSA)
I expect that the property rallies in the US, the UK, and most other countries will be over with prices falling again by the end of the first quarter of 2010. The UK property cycle peaked in Q3-2007 and has lagged more than a year behind the US cycle, which peaked in mid-2006. By the time that QE was working, and ultra-low interest rates began to stabilise assets in late Q1-2009, property prices had fallen only about 20% from the peak in the UK versus a drop of about 33% in the US. Ultimately, I could see both markets falling 40-50% from peak prices, and perhaps more, based on a return to more normal ratios of property prices to income level. If I am right about this, then the UK property has a much further distance to fall from current levels than it does in the US. Sliding property collateral values are likely to cause big problems for banks in both countries over the next 2-3 years.
Ultra-low Interest Rates - How can rates stay down when Inflation is rising again?
For many years, Central Banks kept their interest rates above the Inflation rate. Then, in 2001, in reaction to the panic caused by the 9/11 incident, Greenspan brought down US rates so that 3 months Libor was below the 12 months CPI. To prevent a recession, which would have had a healthy cleansing effect on the economy, he held rates down at zero real interest rates for about two years. That was the beginning of the big trouble for US property. Low rates touched off a speculative boom in property, which became a global phenomenom. As home prices rose, people thought they were getting more wealthy. Banks accommodated the expansive mood, by lending aggressively refi loans and home equity loans. Feeling flush, people began spending more aggressively, and reduced their savings to near zero. The spending and borrowing boom brought many years of high growth, but it was not healthy and sustainable growth, since it was predicated upon easy money. To return to a sensible balance between debt and income, debts will need to be reduced, and malinvestments written down and restructured. Essentially, the US and the UK spent more than 7 years of income in 6 years, and they will now need to spend less than 6 years of income over 7 years or more in order to unwind the excesses. (A simple calculation will show that a shift from 7/6 to 6/7 is a drop of 26.6% in spending.) Such a severe downshift in spending will mean many jobs in sectors like retailing and consumer finance will be lost as spending is cut back. And banks and other institutions that financed the inflated asset values will need to writedown their loans to what is collectible from reduced cash flows.
12 Months CPI is again on the rise in both the US and the UK...
Month : CPI-US : 3mos :12mos / CPI-UK : 3mos :12mo
Sep09: 215.97 : 0.51%:-1.29% / 111.5 : 1.80%: 1.09%
Oct.09: 216.18 : 1.53%:-0.18% / 111.7 : 2.89%: 1.55%
Nov09: 216.33 : 0.92%: 1.84% / 112.0 : 2.15%: 1.91%
Dec09: 215.95 :-0.04%: 2.72% / 112.6 : 3.95%: 2.83%
Inflation in the UK is especially problematic, as the weak currency has spilled over into cost-push inflation from rising import prices. The 12 months CPI rate is likely to push up to 3% above in the first quarter of 2010. The exceeding of the 2% inflation maximum target will require the BofE governor to send a letter to the Chancellor, and this may require a rethink of Britain's ultra-low rate policy.
The UK's zero interest rate "prop job" may have slightly improved Labour's remote chances of being re-elected in 2010, but the rally has had the perverse effect of bringing confidence back to an overvalued market, and encouraging additional highly geared home purchases, some doubtful lending, and more malinvestment in property. If I am right, that the UK has still a long way to fall, then the house price bounce we saw in the UK in 2009. will have served to delay the downturn and make it deeper. The impact on the banking sector will be to deepen the losses suffered by banks, and bring more long term headaches for the UK taxpayer.
A Second US Housing bust?
Meantime, in the US, a second wave of mortgage loan troubles is coming as Alt-A and Prime rate loans reset, from artificially low levels. We can expect to see the 7 million US mortgages presently in default leading to more distressed residential real estate sales, and more downwards pressure on property prices. Commercial real estate in both countries is going to be falling, and that will add additional problems for the banks, and threat to economic growth.
It is impossible to imagine that consumers in the US, the UK and Europe will find they are able to resume the freespending ways of 2005-7 when they could still easily borrow against rising home values. In 2010-13, they will be getting hit with the bill from the lavish years, through increased taxes and the loss of millions of jobs. Economies which became excessively consumer-oriented are going to be forced to slim down. Meantime, governments have been reluctant to tighten their belts, and are trying to restore "the old normal", by borrowing money aggressively, and spending it recklessly on poorly-designed stimulus programs. The foreign holders of dollar, sterling, and euro debts, will try to get the taxpayers to foot the bills for the excesses of their banks and the governments. But there is an increasing risk that taxpayers will revolt, and refuse to pay the full amount of those debts. We have already seen a rejection like this already in Iceland, and it seems this sort of drama will soon be played out in Greece, and the other PIGS countries in Europe, and also in many American states. Eventually, the larger economies of the UK and the US may also face the same problems, when debtors begin to reject lending fresh money to over-stretched sovereign borrowers.
Iceland has shown how this can play out. If confidence is lost, the currency slides and inflation jumps as the price of essential imports rises. At some stage, rates are forced higher (to protect a weak currency) and a country in this situation finds itself in a stagflationary trap. Stagflation is an enemy to stock prices, so if we see this pattern, we are likely to see deep falls in most global stock markets in 2010, 2011, and possibly into 2012. For the US, I expect to see the March 2009 lows of SPX-666 retested within 18 months.
When taxpayers revolt, and banks and governments are forced to default on their debts, then credit markets freeze up, even for sovereign borrowers. I believe that the crisis is likely to spread until some time in 2010 or 2011 when even the UK and US governments will have trouble borrowing. The drama may play out like a game of musical chairs, where as one country defaults, then money flows into the smaller number of countries whose currencies still appear to be sound. More and more chairs may be pulled away until only a few countries are left standing. I believe that the US and the Dollar may stand up longer than several other countries, especially those in Europe. So the perverse effect may be that the Dollar strengthens, despite fundamentals that are not great. Bob Prechter may think that the US may be one of the last currencies left standing. The current consensus would be that the safe havens will be Gold and the Chinese Rmb. I would agree with that, but there is some possibility that it may not play out that way, particularly if China held onto its dollar assets, while selling down its other investments. But I regard this as an interesting long shot, rather than a high probability.
Once a country defaults, it will be likely to face the fate of Iceland. Defaulting countries will have to generate more of their savings internally, since foreigners will be reluctant to lend to them. This will bring higher interest rates, and a severe "stress test" on any business that uses debt. Stock prices will plummet, and weak businesses will be forced to the wall. The US lived through a 1-2 year period like that in the mid-seventies. But the cash flow stress is likely to be even more severe and more long lasting in the years to come. The vulnerability is high, because the US and UK are much more dependent now on foreign sources of capital.
FXI / China stocks - breaking support at $38 ... update
China is an interesting case. The massive stimulus program of 2009 lifted the Chinese economy and helped spur a big rise in exports for commodity producing countries, like Australia, Canada and several Africa countries. But China's huge spending has brought back inflation. According the Wall Street Journal, average prices for urban residential property in China have increased to $523 per square meter in 2008, up from $111 in 1991, or about 9% annually. (By comparison, I estimate the average price of a house in the US to be about $1,200 per sq.m.) Chinese property prices rose even faster in 2009, making even small urban properties unaffordable for the average mainland Chinese buyer. David Hale at the last week's Indaba conference in Capetown, South Africa was predicting a 6-8% inflation rate in China, about twice the concensus. The spectre of this rising inflation, and too rapid lending in the early weeks of 2010 has led China to begin tightening credit. China's stock market rolled over in mid-December 2009. China may again lead global markets lower, as the country finds that its massive investment drive has brought malinvestments in property, excess infrastructure, and factory capacity that will be in surplus to the export potential. By mid-2010, China may find it desirable to revalue Renminbi upwards in order to control inflationary pressures. Meantime, Chinese banks may soon be facing some potential big credit losses.
In a global economy which is beginning to slow again, countries like the US and the UK will find it hard to boost exports. In his recent state of the Union address, Obama gave a target of doubling of US exports over the next 5 years. And Prime Minister Brown has been talking about boosting exports from the UK too. This is unrealistic in a stagnating global economy, where there is likely to be a competition amongst many countries to enhance competitiveness by weakening their currencies. Japan may also want to join this weak currency competition given its slow growth and unacceptably high government debt levels. Where are these countries going to send their exports when every other major country is also trying to boost exports?
A more realistic plan to create manufacturing jobs will be import substitution. With large levels of unemployment, and social support programs under budget pressure, look for countries to try to erect trade barriers to protect their own markets. (We also saw this in the 1930's, when the Smoot-Hawley tariff act of 1930 was enacted. That law has been blamed for prolonging the recession.) At some stage you may hear politicians talking about how a country can lift itself from severe recession or depression through doing more of its own manufacturing. That will only be possible if real wages are allowed to fall, and people discipline themselves, or are forced by import restrictions, to buy more locally manufactured products. So look for these themes to begin to emerge in political and economic debates in 2010 and afterwards.
The US has a special vulnerability in its massive imports of foreign oil. Its net oil imports are over 10 Million barrels per day. At $75 per barrel, that's more than $750 Million daily, and near $300 Billion per annum. If the dollar drops in value - lets say by half - over the next 2-3 years, then we would not expect oil import costs to double. A weaker dollar would tend to push up dollar oil prices, crimping oil demand in the US. Personally, I could see gasoline prices pushing up through $10 per gallon, if the dollar collapses again. Whatever happens in the US, overall global oil demand may hold up as emerging demand from new car owners in China in India, may replace the lost demand from the US. These trends, if they occur, will put special pressure on US suburbanites, who will be forced to drive less, and may even seek to move closer to their places of employment, while increasing their use of mass transit. Banks with mortgage loans against expensive McMansions in the outer ring suburbs will discover a new hole in their balance sheets. Some observers believe that this may increase the demand from urban real estate, especially where there are good transport connections. Already, we have seen that property values in pleasant walkable communities have held up far better than homes in suburban areas. The urban/suburban differential in real estate values is likely to widen in the years to come.
Governments in Western countries can make the harsh adjustments that I have written about less painful by anticipating some of these changes, and halt tax and fiscal policies that encourage malinvestments. Examples of bad policy decisions include: bailouts of auto companies, cash for clunkers, homebuyer subsidies in suburban areas, and federal spending for construction of highways in remote locations. If the government is going to spend money, then it should have an eye on whether the spending will increase or decrease an addiction to foreign oil, and whether it will add or reduce future debt and tax obligations. Borrowing from the future to sustain wasteful consumption habits is a very imprudent policy. This is the is the sort of behavior which needs changing if the US is to get out its debt dilemma.
There was far too much waste imbedded in the programs announced in the 2009 stimulus package. The Planet Yelnick blog called it a "porcullus" program, with huge payments going to wasteful programs designed to win political patronage. Voters are beginning to see through the waste, and will go on "voting out the bums" - as they have done in some recent elections - until they see some genuine change, and more prudent political leadership.
To get out of the mess that Western debtor countries are in, they will need to move away from being consumer-driven economies were 2/3rds or more GDP is dependent upon consumer spending. They will need to learn from the savings-oriented and high-growth economies of Asia. Western countries need fewer shopping malls and a smaller number of credit cards, and more factories and higher savings. Many consumer sectors within the econony should be allowed to wither, while infrastructure that can make an manufacturing-oriented economy more efficient should be encouraged. An big investment like that which Warren Buffett has made in the railroad business anticipates the changes that I am thinking about.
Those who are unprepared and unhedged are likely to suffer a huge loss in wealth
The changes that I am anticipating here will hit many people, reducing the real value of their wealth. The stock market drop we saw in 2008, wiped out an important part of the savings of many American and British households. Home prices dropped 32% and 20%, respectively in the two countries. In millions of cases, people were put into negative equity on their homes. Stock prices fell too, with the S&P500 down 58% from its 1,576 peak, and the FTSE-100 down 49% from its peak.
Index SPX==== : FTSE== : UShomes : UKhomes
Top. : 1,576.09 . : 6,751.7 : $268,476 : 192,490
when: 10/11/07 : 10/15/07 : Jun.06 .. : Aug.07 :
Low.. : 0,666.79 : 3,460.71: $181,025: 153,477
When: 03/06/09 : 03/09/09 : Apr.09. : Feb.09 . :
%chg: - 57.7% . : -48.7% . : -32.6% : -20.3%
Lost.. : -$10.8 tr : -#1.1 tr . : -$11.0tr :-#1.2 tr.
'09yrE : 1,115.10 : 5,412.9 : $190,000: 164,681
Multiply x 11.9bn : 327 mn. : . 126 mn. : . 32 mn
MV'09e $13.3 tr. : #1.77 tr. : $23.9tr :-#5.30tr.
PeakV. $18.8 tr. : #2.21 tr. : $33.8 tr :-#6.16tr.
change: -$5.5 tr. :-#440 bn : -$ 9.6 tr :-#860bn
From falling stock markets and sliding real estate values only, I calculate that US investors lost $22 trillion from peak to trough, and Pds.2.3 trillion in the UK. Much confidence was restored by the nine months rally in 2009. By year-end, the losses I calculate were down to $15 trillion and Pds.1.3 trillion, respectively. As we began 2010, many people believed that conditions were returning to normal, but this still a huge reduction in wealth and the new "normal" that is reliant upon ultra-low interest rates. As some individuals and businesses begin buying again and rebuilding inventories, their purchases have begun to push inflation higher again. The fact is, a genuinely "normal" economy should not be reliant on such ultra low interest rates. The longer rates are held down, the more debt will be built up, and the bigger the ultimate train wreck we will see when rates go back up again.
The stresses are building amongst many over-indebted borrowers, that includes individuals along with the sovereigns and highly indebted companies. 2008's price drops wiped out many personal pensions, and many Americans are now "upside down" on their homes. If the UK property price falls that I see coming occur, then many British will join their American cousins in having negative equity on their properties.
Those who agree with my scenario can protect themselves from further wealth erosion by getting their retirement funds out of the stock market, and selling their properties and renting. The rallies of 2009 have delivered a welcome "window of opportunity" to make these adjustments to family wealth holdings.
The question that remains, if you get out of stocks and property, how do you hold your wealth? I favor a risk-averse approach. I would not hold debt instruments, and I would steer clear of most stocks, and be very suspicious of high dividend stocks, which may find it tough to maintain cash flow for dividend payments, if their cash flows wane in a shrinking economy. We are coming into a time when "cash will be king" once again. But cash must be held in sensible currencies, and in safe institutions. I would avoid stashing money in currencies of debtor countries which may be headed towards default. And bonds of those countries are even worse, since capital values will fall, if they indulge in aggressive money printing. This leaves the savings nations, like China and some other countries in Asia (like Singapore), and some special cases, like Norway, which have little or no debt, and big oil savings.
I have some money held in US dollars for the time being, since that currency is benefiting from an unwind of dollar-carry trades as stocks and other assets are sold. We saw a similar upthrust in the dollar, when de-leveraging hit in 2008. When the dollar begins to falter, and commodities begin to bottom out, I may consider moving more deeply into the currencies of commodity exporting countries, like Canada and Australia. Even now, I continue to hold a decent part of my cash in C$.
There is certainly a role for Gold in a low risk portfolio, since it can be regarded as the only "currency" which is not someone's else's liability. As long as it is held safely in physical form, there is zero risk of a credit default. You are not relying on someone's willingness to pay, or their vagaries of cash flows from tax collections or volatile business activities.
I will take some risk, but it will be in a measured way involving a minor part of my portfolio in leveraged instruments like puts on the general indices and volatile junior mining shares. This way, I aim to protect the bulk of my portfolio, by leaving it invested in save haven instruments, but I may still be able to grow the size of my portfolio, by investing a minor part of the total portfolio in high-geared "bets" when opportunities appear.
The next few years will be full of challenges for investors, and for anyone who is seeking to maintain their present living standard. The good news is that a more frugal approach, which most of us will be forced to adopt, does not necessarily mean a major decline in the quality of our lives. When we have less money to spend, we will discover that the best things in life cannot be measured with money. Perhaps golfers will find pleasure in gardening, or luxury yacht owners will become keen fishermen. We will all have a great chance for remaking our lives in creative ways. We are likely to have more time on our hands, and many of us will rediscover some forgotten aspects of living that really matter, and bring a rich texture to life.
*My scenario is only one of many. Shared characteristics of the ones that I find most plausible are: a drop in the currencies of Western debtor countries, higher interest rates, and a need to replace the flows of cheap capital from Far Eastern savings countries with more internally-generated savings within Western countries. The days of wasteful consumer-oriented economies may be numbered.
- More Charts, follow the link to GEI.
- Iceland - Beyond Financial Collapse
- DrBubb & Mish Shedlock, on 2010
Copyright © 2010 Michael Hampton