The Last Wave
by James J Puplava CFP, President & CEO, PFS Group. April 12, 2002
Was That Really a Recession?
One of the more remarkable aspects of this recession was how short and mild the economic decline turned out to be. In fact, outside of manufacturing and the drop in corporate profits, it hardly resembled a recession. Housing remained strong. Consumer spending continued to hold up. Stock prices, excluding the Nasdaq, held up well with only a modest drop in the Dow and a low double-digit loss for the S&P 500. If it was a recession, it appeared to be a mild one at that. Some even doubt whether it actually was a recession. Most recessions are characterized by two consecutive negative quarters in GDP growth. In this recession, we had only one quarter of negative economic growth. The economy actually grew statistically in the fourth quarter 2001.
With stock prices recovering since their nadir last September and spring in the air, everyone is talking about economic recovery occurring during the second half of the year. Although it may be possible, it is unlikely to occur. Already some firms are starting to hedge their bets on the second half recovery scenario. Like past recessions, the basis for recovery is the end of inventory liquidation. As manufacturers work down their inventory levels, they are expected to start rebuilding them again in anticipation of future demand, which becomes the building block of the next recovery. However, the Fed, and in particular Alan Greenspan, have warned repeatedly that unless demand picks up from business in the form of capital investment, this recovery isn't sustainable.
Since the terrorist attacks of last September, inventories have been reduced dramatically, government spending has surged in the wake of war, and consumers have gone deeper into debt to maintain consumption. However, this increase in economic activity may turn out to be short-lived. Housing and consumer spending, supported by lower interest rates has fostered greater debt accumulation. This rebound in economic activity was possible only through additions of debt. Our government, corporations, and individuals went deeper into debt to pay for consumption. Capital investment by business has been conspicuous in its absence. Plummeting profits were responsible for the downturn in business activity, which gave way to a recession. It is this dearth in profits that will prevent the capital-spending boom from occurring and it will make any further increase in economic activity unsustainable.
The Last Wave: "The Three Sisters" - Consumer Debt, Corporate Debt, and National Debt
What is ignored in most economic analysis that I read is the role that debt played in the economic boom of the late 1990's. This mounting debt burden will bring about the deflationary recession/depression that I see unfolding. One of the hallmarks of the 1990's was its bubble-like character. Credit and debt creation during the last boom seemed to have no limits. Consumers stopped saving and went on a borrowing and spending spree. They borrowed to consume and they borrowed to invest. Savings shrank to zero, mortgage debt rose, revolving debt expanded, and margin debt increased. This week a prominent ad on local radio is to log on to officialpayments.com and pay your taxes with credit.
These graphs show that as debt accumulation grew, savings fell. This now leaves the consumer with no cushion to weather an economic downturn at a time when savings is most needed. This lack of savings and rising debt levels will be contributing factors to the deflationary debt implosion that will shortly be upon us.
While consumers were on a debt and spending binge, corporations took on debt in ways never seen before. Many companies went on a merger and acquisition spree in an effort to acquire sales and earnings growth to drive up share prices. Money was borrowed to buy back stock and other companies at inflated prices. This process is now unwinding as company after company writes down over-inflated goodwill. It is estimated that this goodwill write-down will amount to $1 trillion dollars, reflecting the greatest destruction of shareholder value in history. It is this destruction in shareholder net worth that is now obfuscated by the widespread use of reporting pro forma earnings. The pro forma numbers don't reflect the dirty laundry.
Today, Corporate America is having to pay the piper for their proliferate spending, debt accumulation and errors in business judgment. Instead of spending money on plant, equipment and modernization, companies embarked on a merger and acquisition binge that actually contracted the economy. The downsizing, cost cutting, and payroll reductions spawned from these mergers actually reduced output and economic activity. In essence, companies were consuming the nation's productive seed corn. New investments weren't being made that would have contributed to productive capacity and income generation within the economy.
From a macro sense, corporations were invading their competitor's turf by cannibalizing each other's sales and earnings. The downsizing, layoffs, and exporting of jobs reduced economic income. When workers are laid off or when pay and benefits are reduced, a source of income is removed from the economy. This loss in employment income was replaced by additional consumption financed by debt. Collaterally, this additional debt has also raised their interest expense.
A larger corporate debt burden has been one of the main reasons why profits have fallen so precipitously. With interest rates rising and balance sheets loaded with debt, many companies have been forced out of the commercial paper markets. Companies have used the commercial paper markets as a source of cheap financing for current operations. Locked out of the commercial paper market by lower credit ratings and tougher lending standards, companies have had to tap into the long-term debt markets at much higher interest rates. This will further increase interest expense, which in turn will lower earnings. It is one more reason why the use of pro forma earnings is so prevalent since it excludes interest expense.
In addition to added interest expense, companies are now forced to write off impaired assets known as goodwill when its value is no longer substantiated. This is another profit killer, which is swept under the carpet when pro forma earnings are reported. If goodwill write-downs didn't matter, then they wouldn't be reflected in stock prices. A look at the stock price of AOL Time Warner and JDS Uniphase shows that the market intuitively knows the difference.
As the graph of total American debt illustrates, America has now become the largest debtor nation in the world -- a trend that is not sustainable. No nation can borrow its way to prosperity in perpetuity. From our government and corporations to its citizens, debt permeates every sector of the American economy. One of the hallmarks of America's economic boom years during the 80's and 90's was the remarkable change in individual financial behavior. Individuals went from the accumulation of liquid assets to illiquid assets to the addition of liabilities. Mass marketing of debt and the disintermediation of credit in the financial system lessened the appeal of cash with consumers.
Net household liquidity turned negative as individuals transferred liquid cash savings into less liquid securities with stocks, bonds, and mutual funds. The higher returns offered by financial assets made the financial markets that much more alluring to all sectors of society. From senior citizens dependent on investment income to pay bills to younger indebted households looking for higher returns to supplement the lack of savings, financial assets replaced cash. As memories of the depression and post-war hardships faded, a new generation of Americans took to the credit markets like a duck to water.
The thrift-conscious, buy-with-cash culture has disappeared. The revolution in the credit markets, the wave of technological change in the financial industry, and the plethora of financial products and means for borrowing money has been embedded in the American way of life. The willingness with which debt is assumed is one of the more dominant aspects of the American economy. From the ubiquitousness of credit cards, home mortgages, home equity loans, margin debt, to installment debt, credit has securitized and mortgaged the entire asset base of the U.S. economy. We have become our own worst enemy and day after day, we sink deeper in debt.
While Americans no longer have an aversion to debt, they also unwittingly changed their aversion to risk. With the financial markets offering consistent double-digit returns for close to two decades, investors lost sight of the risk aspects associated with most financial instruments. Investor preference turned from safe investments like cash, bonds, and gold to equities and property. Fear of loss of assets or wealth has completely disappeared. The superior performance of financial assets these last two decades has completely anaesthetized investors from the pain of wealth destruction. It has been nearly three decades since the last real bear market of 1973-74. This absence of fear has been replaced by a myopic belief in paper assets, real estate, and a confidence in central banking to uphold these asset values -- a confidence that is historically misplaced.
It is now this preponderance of debt and the reduction of returns on financial assets that present the U.S. with the possibility of a financial breakdown. The prosperity of the U.S. economy is every bit as dependent on foreign capital as it is the perpetual creation of domestic credit. The U.S. has been running continuous budget and trade deficits for more than two decades. These deficits, in particular the current account deficit, have been viewed in financial circles as a sign of affluence and influence in the world community. The growing government budget deficits have made the U.S. bond market the largest debt market in the world. Make no mistake: the U.S. economy runs on credit. Devoid of domestic savings, it is dependent on outside sources of capital to finance internal consumption. The result has led to a burgeoning mountain of debt.
Foreign investors now hold a good majority of this debt. Any one of these foreign sources -- whether a foreign central bank, offshore hedge fund, or overseas institutional investment fund -- could trigger a debt and dollar crisis. Problems in Japan could lead to the repatriation of capital back home. A growing confidence crisis triggered by accounting and earnings scandals could cause foreign capital infusions to drop off or be withdrawn. If monetary inflation by the Fed continues, hedge funds may withdraw capital sensing a rekindling of inflation.
In the thirties, Ludwig von Mises warned about the dangers of �Hot Money� when he wrote, �Many capitalist became anxious to protect their capital against their own government's policies of confiscatory taxation, open expropriation, and devaluation. [All three currently exist in the United States.] They entrusted their funds as demand deposits to commercial banks and bankers of countries whose currency conditions at the moment seemed to be worthy of more confidence. As soon as doubts concerning the stability of this country's currency appeared, they hurried to withdraw their balances and to transfer them to another country in which the risk of an impending depreciation seemed less likely.� 1
Credit Inflation = Debt Implosion = Deflation
A more likely scenario is an implosion of the debt markets that begins with the gradual erosion of credit quality. On the day this Storm Watch Update was written, Moody's Investor Services released a report showing that corporate credit quality continued to deteriorate sharply during the first quarter of this year. Downgrades exceeded upgrades by 4.7 to 1. The first quarter was the steepest decline in credit quality since the fourth quarter of 1990 when downgrades jumped to a 6.3 to 1 margin. Moody's was hopeful that a rebound in corporate profits could narrow the gap. 2
Credit inflation expands the availability of credit in the financial system and into the economy. As credit is expanded, the quality of credit begins to decline. This leads to defaults and bankruptcies as the total volume of credit outstanding becomes less likely to be repaid. This is what S&P, Moody's, and Fitch are now reporting. It is the unwinding of the 1990's credit boom. The process begins gradually and picks up momentum with the expiry of the speculative fever in investing and lending.
What needs to be understood is that history teaches us that all credit inflations end up in a deflationary credit collapse. Overburdened consumers eventually realize that their present debt circumstances can no longer be supported by their labors. Once this realization is made, they will have two choices. One will be to carry on until they are forced to default. The other choice is to reliquify their balance sheet, which would involve the sale of assets, downsizing, or reduced spending. Either choice is deflationary.
Businesses, on the other hand, can reach the same conclusion with similar actions. Once a business that is heavily laden with debt realizes that profits and cash flow can no longer support debt service costs, they immediately begin to retrench or restructure. Assets are sold, payroll is cut, and all plans for expansion are curtailed. This is exactly what you are seeing now in corporations large and small. These actions have become part of the daily news landscape.
Credit Contraction Leads to Debt Deflation
This downsizing continues until the financial system cleanses itself. It normally begins during a recession. The greater the credit expansion, the greater the cleansing process when it begins. This process gives way to a paradox whereby the rational behavior of balance sheet reliquification triggers deflation through falling asset values. As assets are sold, either voluntary or involuntary through bankruptcy or default, asset values fall sharply. Under either circumstance the markets are flooded with an excess supply of goods -- be it stocks, bonds, real estate or plant and equipment. This, in turn, triggers a loss in the value of collateral used to support loans made by banks. As this takes place, banks become reluctant to lend or renew credit. Credit contraction and debt deflation is the result. The last pillar of the 90's credit bubble has been the real estate market. Do not be surprised if you begin to see this deflationary process unfold in this sector in the near future.
In his book Debt & Delusion, Peter Warburton expands Hyman Minsky's theory of debt deflation originally developed by Irving Fisher. Warburton summarizes Minsky�s arguments well when he writes, �Minsky argues that a high debt-equity ratio increases the inherent instability of the financial system. Businesses are tempted to borrow to excess when interest rates are low in relation to anticipated profits growth or asset price inflation. Whereas dividend payments on equity can be reduced or suspended, debt contracts must still be serviced, and thus the risk of bankruptcy increases.� To this Warburton adds the summation of J. Presley and P. Mills from Islamic Banking: Theory and Practice, "� when asset values are appreciating faster than debt service costs, profits are maximized by leveraging purchases as much as possible. Banks and bondholders are able and willing to supply credit, possibly at declining real interest rates, as risk premia are reduced when collateral values are appreciating. As investment expands and prices rise, profit expectations will be validated and further investment encouraged�. 3 This is exactly what we are now seeing take place in the U.S. domestic real estate market.
Eventually, as Warburton points out, the speculative frenzy is brought to an abrupt end through rising real interest rates either through a shortage of liquid savings or through the actions of the central bank, which raises interest rates. If this sounds familiar, it is because this is now taking place in the credit markets. Since this process is a gradual one, the financial markets have been lured into a false sense of confidence. The second half recovery mantra is promptly repeated which induces complacency. Yet credit spreads have widened reflecting an increasing risk premium in the credit markets. This is forcing companies to tap the long end of the market or to exchange long-term debt instruments through the derivatives market in the form of credit swaps. The future cost of this burden is a big unknown. However, in either case, the cost of interest is rising for most companies. This is cutting into profits.
Inflation, Deflation, or Both?
The real question now is will inflation or deflation be the eventual outcome? I believe we will have both. For the majority of the economy, deflation will be the case. The confluence of factors, from contracting credit patterns to falling asset prices, point to the dominance of deflation for the majority of the U.S. economy. The collapse of credit produces the opposite of credit inflation. When credit is added to the economic system, it produces above-normal demand for goods and services driving up their price. A credit contraction causes the reverse action. The Long Wave Analyst editor, Ian Gordon, writes "This collapse of credit causes the deflation of values, a contraction of demand and the dumping of surplus properties and inventories at sacrifice prices; together with a sharp and prolonged rise in unemployment; all of which are typical of a depression." 4
Gordon continues, "Once the credit bubble starts to deflate there is little recourse for the Federal Reserve because, to expand credit, you must have willing lenders and willing borrowers. However, when the scramble to get out of debt and to salvage a portion of the outstanding debt starts, there are simply no more willing or credit worthy borrowers left. A credit crunch begins when a large number of borrowers, each desperate for cash, try to tap a rapidly diminishing pool of credit. Long-term interest rates rise when investors flee from long-term bonds to the shortest terms and most liquid cash equivalent, such as Treasury Bills. Thus, the only place to be invested at the approach of a credit crunch is in short-term highly-liquid depository accounts". 5
In The Long Wave Analyst, Gordon describes the pattern and bust that renews itself in each credit inflation cycle. We've gone through the boom period. Now comes the bust. However, history never repeats itself in the same way. Patterns and outcomes may be similar, but never the same. There are unique circumstances in this last credit boom, which are going to make the next bust cycle different. They are the product of the parallel financial system that mutated out of the 1970's inflationary experience. The transference of the credit creation mechanisms, outside the banking system and through the securities market, has created a uniquely different set of circumstances. One of which has been the explosion of risk transfer vehicles known as derivatives. These financial instruments have allowed the expansion of leverage to an unprecedented degree never thought possible before. This has led to an operation known as "gearing." Gearing is a process in which derivatives are used to gain control of a more expensive financial or tangible asset through the use of leverage at a very low cost. It allows for dominance of an asset class at a fraction of the cost of direct ownership.
Paper Markets Control Physical Markets or Why We Have Investment Fractional Reserves
This process of leverage has been the main vehicle by which central banks have waged war against tangible assets in order to keep their prices suppressed. It has also allowed hedge funds to place sizable bets on everything from currencies and interest rates to commodity prices. A small amount of capital can control a much larger asset class. It doesn't matter whether that asset class is gold, silver, oil or a currency. The point to understand is that the paper markets control the physical markets and not the other way around. The explosive use of derivatives and the amount of leverage they employ has become the financial equivalent of fractional reserve banking for the investment world. The whole system works as long as confidence in the system is maintained. Should confidence evaporate, the system would implode if settlement were made in the physical rather than in cash.
The process of gearing has controlled the commodity markets for decades. It has kept prices low; while demand for products has expanded. This runs contrary to general economic laws. As a result, the growing world population's demand for everything from gold, silver, oil, natural gas and food has expanded; while their prices have declined. This has led to disinvestment, divestiture, and contraction of most commodity -like businesses. We've seen that most commodity-type business have contracted, consolidated or merged which has further reduced supplies. In many commodities such as gold, silver, oil and natural gas we are living off decades of accumulated reserves in order to meet demand. This is a process that can't go on indefinitely. Eventually the process will reverse itself when accumulated inventories and stocks are drawn down . Raw materials have gone through a bear market that has lasted more than 25 years. No new refineries have been built in close to two decades and we wonder why gasoline prices jump when supplies get tight due to demand. There isn't any excess refining capacity.
In most commodity markets whether it is mining, agriculture or energy, the business has contracted due to lower prices and the lack of incentive to expand. Most equipment and machinery have deteriorated, been cannibalized, or operations have been shut down to save cost. This reduces supply each year as demand continues to grow due to increasing populations and the spread of capitalism around the globe. Above-ground stockpiles are rapidly declining. Yet the price of most commodities remains suppressed. And nobody thinks this is odd? This is all made possible through the control of the physical markets through the use of paper assets known as derivatives. It is part of a financial system that does not allow alternative pricing mechanisms to provide benchmarks for comparison. This process cannot be maintained indefinitely despite the best efforts of central bankers. Clyde Harrison of Beeland Management and manager of the Rogers Raw Material Fund said it best, "The last central banker to get it right was Joseph in the Bible, seven good years followed by seven bad."
The final aspect that will make raw materials more valuable during a time of general price deflation in the economy is war itself. During periods of war certain commodities become more important. They are essential to the successful prosecution of the war. We are constantly reminded of their importance in the daily fluctuations in the energy markets. It is inconceivable to most economists and politicians to grasp what would happen to western economies if the flow of oil is shut off or disrupted due to war (Iraq embargo), curtailed by labor strikes (Venezuela), or threatened by guerrillas (Colombia). Yet the Senate in the U.S. dithers on energy policy totally oblivious to the precarious situation the U.S. now finds itself for lack of an energy policy. It is not only arrogance, but it is stupidity. Suffice to say, war adds another dimension to demand that is unforeseeable or known at the onset of war. This aspect will be explored at length in the next installment of Powershift: The Politics of Energy.
Scientists describe a rogue wave as a set of three mounting waves called "The Three Sisters." The wind pushes the triple set of waves into a stacking pattern which eventually forms one large wave. Today we are seeing a rogue wave developing which could easily be "The Last Wave" to hit America's shores. America, it is time to make the choice. Get out of debt. ~ JP
- Von Mises, Ludwig, Selected Writings of Ludwig von Mises, Liberty Fund, Indianapolis, 2000 (Estate of Ludwig Von Mises), p. 100
- Credit Market Trends Service, "US corporate credit worth declined again in 1Q2002 but slowing seen," Moody's.com
- Warburton, Peter, Debt & Delusion, Trafalgar Square, 1999, p. 224.
- Gordon, Ian, The Long Wave Analyst, Volume 4, Issue II, p. 8.
- Ibid., p. 8.
Cover graphic by Adam Puplava
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