Monday, December 22, 2008

Themes for 2009 - Part 2 (Macro Outlook)

A few years ago I attended a resource and investment conference in Vancouver where Dennis Gartman was one of the major speakers on a panel with some others. As is customary at these conferences, those who are known as “Gold Bugs” are the majority, while anyone else is a decided minority. Gartman dislikes gold bugs. But he was a gold bull for many years because he thought it was undervalued – hence, his invite to this conference.

But the topic of gold was not what stuck in my mind from that panel. The gold bugs were ganging up on Gartman on the issue of government and consumer debt. “It's all at record levels,” they claimed. “That can't go on forever!” But Gartman was a veteran. He'd been around commodity markets for decades. He'd heard these arguments since the 70's. “Consumer and Government debt has been at record levels for 20 years. Each time I hear that it can't go higher, it does. Why should now be any different,” he responded. (paraphrased)

To an extent, I agreed with Gartman. But surely, it couldn't go on forever. Eventually, all those years of debt not mattering would catch up to us. All of a sudden it would matter again. Cracks started to show in February of 2007, when subprime lenders started going under. Fremont General, New Century Mortgage, etc. The list began to grow. I remember being one of the first 100 visitors to the mortgage lender implode-o-meter website back in 2006. 37 million have since visited.

What began as a collapse in a tiny portion of the mortgage market started to spill over to the incredibly leveraged balance sheets of those who had invested in their securities. Credit was tightened. Home prices reacted by falling further. We learned that it wasn't just subprime paper in trouble. The market for all mortgage securities dried up. Hedge funds collapsed. Forced liquidations caused a further acceleration in all of the former. What we thought was a common cold turned out to be pneumonia. Pretty soon jobs started to be lost. Stock prices plummeted. The same problems emerged in Australia, New Zealand and Spain. Then the UK and Ireland. Then it was nearly everywhere.

All along we were told that the problem was nearly over and would not get worse by the most respected economists in the world. Just as we were told by the CEO's of major financial institutions that their financial conditions were “solid” mere days before going out of business.

“At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” Ben Bernanke, March 28, 2007.

“Clearly, no one’s got a crystal ball. So there’s always a possibility that there will be a downturn, always a possibility,” Paulson said. “But I don’t see it. I think we have a healthy economy in the U.S. You know, a year ago, when the growth rates were much higher, I was concerned. I said, ‘Is this going to be sustainable?’ Now I’m looking at it and I’m seeing a situation where it looks like we’re successfully making the transition. We’ve got a very healthy labor market.” Hank Paulson, March 5, 2007

Those were just two of the more appalling examples. But the idiocy was widespread. Even as 2008 rolled on, people were still debating whether or not the US would enter recession. Well respected TV personalities ruminated over “soft landings” and “cinderella economies” (low inflation, positive growth.) Even pessimistic economists tinkered with their 'probabilities of recession' forecasts (think Roubini). We found out a few weeks ago that the recession actually began in December of '07.

What couldn't go on forever stopped.

To me, the most important manifestation of this worldwide crisis is in the change in psychology and the resultant change in consumer behaviour. Previously, saving money was of no real use. Everybody “knew” that buying assets was the way to get ahead. Assets always rose or at least held their value. But that psychology has changed. Prices have begun falling, and people would far rather save their money or pay back debt than buy something that is falling in price. Banks appear to be operating on the same premise. Interest rates are so low, that lending money to someone makes very little sense. Additionally, banks are skeptical of what consumers intend to do with their loans. If they plan on buying a depreciating asset, then the banks see a higher risk in lending the money, because the collateral behind the loan may be less if and when the consumer were to default.

In other words, deflation seems to be self-perpetuating itself. The US Federal Reserve, Government and Treasury Department have already injected 3 Trillion dollars to the financial system in 2008. Foreign governments have added to that total substantially. Yet whether or not they give it to banks on loose terms or whether they give it to consumers directly doesn't seem to make much of a difference. Nobody can find an economic use for the extra money.

It is difficult to comprehend how much 3 Trillion Dollars is. Robert Prechter did an interesting analysis of previous government expenditures adjusted for inflation to try and grasp how big this 3 Trillion is. He concluded that 3 Trillion would have been enough to pay for all of the below:

The Louisiana Purchase
The Marshall Plan
The New Deal
The Korean War
The Race to the Moon
The Vietnam War
The S&L Crisis
The Gulf War
The War on Terror

World War II cost 3.6 Trillion in today's dollars.

Okay, so 3 Trillion is a lot of money. But it doesn't appear to be working. It just gets sucked up by the balance sheets of banks who hold hundreds of billions worth in derivative contracts that now, apparently, have little or no value. Don't fear. There has been an additional 5 Trillion earmarked for the same purpose.

Most believe that eventually banks will start lending again and people will start borrowing again, and the game will start all over. To me it is clear that this will never work. My reasons are that psychology has already been impaired and will not be repaired until two preconditions have been met:

1)Enough time has elapsed for people to forget about the crazy speculation of the past
2)Asset prices fall by a large enough degree that they reflect the average person's ability to purchase them with the fruits of their labour

To the first condition, there is nothing government can do. To the second, the best thing government can do is nothing.

Therefore, it is my belief that the deflation I have thus far correctly anticipated will be a continuing theme in 2009. Asset prices will continue to fall and credit will continue to contract – all against the wishes of our central bankers and despite their efforts.

This will have further implications for struggling businesses that have too high a debt burden. Airlines, commercial property operators, utility providers, and retailers are all going to have enormous pressures put upon them in 2009. General Electric is one company that I do not foresee surviving in it's current form.

Unfortunately, one of the easiest ways for these companies to buy themselves some time is to cut staff. We have already seen mass layoffs on a terrible scale. I believe it could get worse. Specifically, I have my eye on the US non-farm payrolls number for January (scheduled for release on February 6th.) January and July are months when the BLS (Bureau of Lies and Shenanigans) restates all of their numbers for the previous 6 months. Their continued usage of the birth/death model has made recent numbers look far better than they actually are.

The rapid decline in asset prices, slowing business activity and subsequent unemployment is going to have grand implications for the overall economy. As the year wears on, the “D” word (depression) will start to become more widely accepted. The consensus view for a second half recovery will be pushed back yet again as it becomes apparent that monetary stimulus is having little effect on the credit markets.

As can be seen, I am still pessimistic on the US economy. But also on the economies of it's trading partners. I was previously optimistic on the prospects for the Canadian economy, even though I thought we would see a recession. But the dramatic decline in commodity prices along with the impending decline in real estate prices will be developments that will weigh on the economy for all of 2009.

The European manufacturing sector seems to be suffering as well. Real Estate declines are accelerating which is likely to put even more strain on the troubled banking system. I am seeing increasing signs of civil unrest here in Europe. The nightly news in Germany is often filled with instances of mass demonstrations in various cities throughout the EU. Most notable of these can be seen right now in Greece. But as joblessness increases and budgetary strains occur at a disproportionate level across the EU, I wonder how the proverbial cookie can avoid crumbling.

Another problem area I see for 2009 will be China. Europeans and Americans will not completely stop buying cheap stuff, but they will buy less of it – regardless of the price. And that translates to job losses in China. We have already seen enormous declines in Chinese manufacturing growth, but further declines have been seen in electricity output. For the economy that was slated to “overtake America by 2020,” I am expecting the unthinkable for '09: economic contraction in China.

But perhaps more notable than the worldwide economic contraction will be the social aversion to materialism that is it's original cause. This is one area I see becoming readily apparent to most in 2009, as it was only something one would notice if they were looking for it in '08. A vehement avoidance of any outward expressions of wealth, excessiveness and risk-taking will be one of the major themes for the coming year. I see the average person, who will undoubtedly start to feel the effects of the contraction (if they haven't already), as setting their sights on who they perceive as the perpetrators of the crisis (anyone in large amounts of debt, bankers, real-estate agents, stock brokers, etc.) The social witch-hunt of sorts will result in lower executive salaries and, less discretionary spending, increases in the savings rate and surely other unforeseen consequences.

In subsequent parts I will discuss what implications this economic outlook may have on equity markets, commodities and major currencies.


Aaron Krowne said...


We appreciate the mention. However the link to our web site is broken. Thought you might want to know.


Aaron Krowne

Matt Stiles said...

Hi Aaron. I corrected the link on my page.

All the best,


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