Sunday, July 5, 2009

Themes For 2009 - Mid Year Review

Since I began this blog, every year I have written a fairly lengthy year-end series of posts dealing with various asset markets and macro trends that I feel the world of finance will experience in the upcoming year. Earlier posts for year-end 2006 and year-end 2007 can be found at those links. My year-end 2008 article will be the topic of discussion today.

Because these articles are dealing with fairly specific predictions, I offer my usual disclaimer. "Some of these predictions will turn out to be right. Some will turn out to be early. And in hindsight, some will be laughably false." Such is the predicament when one puts his or her opinion on the line and offers it for all to see. But as I often say, writing a blog like this offers an inescapable glimpse of the thought-process of one's past. And if learning from one's mistakes is how we make progress, then there is no better way to ensure mistakes are learned from.

Do note, that with six months remaining in the calendar year, and the rapidity in which things change, that is quite a long time. Also keep in mind the atmosphere that these thoughts were first offered in. The S&P 500 was trading right around where it is today, and the consensus was, like now, that we had hit bottom. Most wall street analysts were projecting much higher stock prices for the year - an outcome that, despite our enormous rally, has not transpired as of yet.

With out further ado, here are my list of themes for 2009, with my current thoughts in bold.

- Government attempts to "get credit moving again" will fail. The credit contraction (deflation) will continue even as governments and central banks do everything within the law (and even some outside) to encourage hyperinflation I'm claiming victory here, but know that others will beg to differ.

- Crumbling corporate earnings as consumer psychology moves away from the "gotta have it now" mentality to "it can wait until next year" Earnings are soon to register negative (12 month trailing) for the first time ever

- Municipal and State bankruptcies requiring federal bailouts in the US happening

- Skyrocketing unemployment. Official figures to reach 9% or higher in the US. Almost wrong for being so optimistic. At the time (7.4%) this was a bearish call

- Worldwide social unrest or even war as currency collapses, unemployment and falling asset prices shake people's faith in their governments and scapegoats are made of traditional enemies Not yet

- Plummeting stock markets worldwide with losses of 50% or more in major indices as hype over President Obama wanes Stay tuned. 50% figure might take longer (ie. 2010) than I anticipated

- A wave of bankruptcies in retail, restaurants, airlines and financial services. Nationalization of the politically well-connected Happening. Will accelerate

- A continued strength in the US Dollar vs most other major currencies as European infighting escalates Dollar still flat on the year

- Declines in the price of gold but continued relative outperformance to other assets and most currencies Wrong so far. Gold up $50 on the year. Underperforming other markets

- Large declines for Canadian real estate, notably in bubble areas of the west and prairies Still flat

- Social "witch hunts" for those responsible for the common plight. Multiple scandals uncovered. Persecution and enormous tax increases on the extremely wealthy Only just begun

- An increased focus on the family, on close friends and "time" in general Not really quantifiable. But I'd argue it's happening

Ultimately, I was arguing at the beginning of 2009 for a continuation of the trend that began in 2008. Two days after writing the above, the markets made their high and lost another 30% as the deflationary trend did, in fact, continue. But that two month decline was met with a near 4 month rally that put us right back where we started the year. The size and length of this rally, and the possibility of it continuing further force me to moderate my expectation that all of the above does not happen within the calendar year, although I still lend it a greater possibility than most would.

Contrary to what we're made to believe by the same people who saw none of the obvious signs of an impending debt crisis, the economy is not "rebounding" as it is normally expected to do. The neoclassically educated economists and analysts making these proclamations do not consider the amount of debt as a problem. Instead, they blame the crisis on a spontaneous and inexplicable loss of confidence and propensity to "underconsume." They base this assertion on a complex mathematical model that was formulated from a non-neutral starting point. "Equilibrium" in our economy, they say, was the 2006 housing mania. Equilibrium, was people buying a new car every 3 years and a new flatscreen television every 2. Equilibrium was when the savings rate was near zero and unemployment was around 5% (full employment), while economic growth was hovering around 3%. And since the economy "tends to revert toward equilibrium," then any deviation from it is suggestive of nothing other than an inevitable return to that equilibrium. The further it strays, the more likely it is to return. That's what the model says.

Hence, anytime over the past 4 months when monthly statistics are reported to be "less bad" than the previous month, it is determined by these economists that the reversion to equilibrium is occurring as expected (ie. green shoots).

The fly in the ointment to all of this, of course, is debt. In the mind of a neoclassical economist debt does not matter because for every borrower, there is a lender. The fact that this lender has created a good portion of this debt ex nihilo (out of nothing), and that it was inherently used to finance investments that couldn't have otherwise been funded from voluntary saving does not enter into the equation. To what specific part of the economy was this debt primarily directed? Will those investments be completed? If they are completed, will there be adequate demand for the product or service offered? The models cannot answer these questions.

So for the same reason that these economists failed to see the problems building through the middle part of this decade, they will fail to see that the same problems remain now and will persist until they are mostly eliminated in the form of liquidation. This entails pain and lots of it.

Federal governments and central banks have taken it upon themselves to try and offset these liquidations by going into debt themselves, or by purchasing securities for greater than their market rates in order to prop up their prices. Do note, that no price fixing campaign in the history of the world has been successful for any considerable length of time. Which is why I believe that the attempts by the Fed to price fix are failing, and will continue to do so.

It is often said that the Fed's balance sheet is exploding. That may be true, but like any other bank, it will be interesting to know what the market value is of all of their holdings should they be marked to market. Whether they choose to make that information available or not is not relevant. They could attempt to hold the securities to maturity, at which time they would be forced to write down the value. Impaired assets are impaired assets. Delaying the acknowledgement of true value does not mean that the losses have disappeared. They have simply been delayed - precisely what was done in Japan. Banks in Japan that held overpriced assets like Tokyo office buildings on their books ended up taking the losses slowly over the course of 20 years, rather than in one fell swoop. The banks themselves knew this, so they were required to keep reserves for those eventualities. The Japanese consumer knew this, so there was no incentive to invest in assets that were guaranteed to steadily decrease for many years. The rest is history.

Australian economist Steve Keen had some observations recently along the same lines. Keen is a proponent of Hyman Minsky's "financial instability hypothesis" and rejects most of the neoclassical dogma. I cannot agree with everything he says, but he is definitely worth the read. Below are some of the charts he posted in his most recent article: It's the deleveraging stupid.

The first is a chart of US private debt (red) and US public debt (blue) expressed as a percentage of its impact on GDP. This should make it fairly clear which is the most important factor overall. But everyday I am confronted with people who seem to believe that an increasing amount of public debt is going to drive the US into hyperinflation. Private debt is contracting far faster than public debt is growing. And it is the total amount of debt that matters in determining the purchasing power of the US dollar.

Put together, here is the total amount of US debt as a percent of GDP.

Keep in mind, none of this is inclusive of trillions in debt that has yet to be acknowledged as a loss, much of which are opaque derivative instruments whose values are now solely derived from the counterparty's ability to stay alive, rather than on the underlying asset - yet another factor that neoclassical models failed to foresee. Oops. As always, aggregate charts like these fail to tell the whole story, but that is only further supportive of the argument for debt deflation.

Another argument can be found in a recent article from CFO magazine, "Banks Take Aim at Revolvers"

Some exerpts:

Banks are cutting the size of revolvers, upping interest rates, shortening maturities, and enhancing their collateral positions, regardless of where companies fall on the credit-quality spectrum, says the report, written by analyst Chris Taggert.

Revolving lines of credit are a critical capital source for payroll, buying raw materials, and paying rents, as well as a liquidity backstop for commercial paper. Higher rates and reduced capacity on such debt can mean companies have to consume more of their cash on hand in daily operations.

Data from banks backs up CreditSights' findings. Unused commercial-credit commitments at large banks shrank in the first quarter, according to a review of call reports by Citigroup's unused commercial credit commitments dropped to $262 billion in the first quarter of 2009, down from $405 billion a year earlier; JPMorgan Chase's obligations fell to $247 billion, from $311 billion; and Bank of America's dipped to $269 billion, from $305 billion.

What's more, new issuance of corporate revolvers continues to plunge. In the first half of 2009, banks issued $163 billion in new revolving lines of credit, down from $292 billion the first half of 2008, according to new data from Reuters Loan Pricing Corp. Total issuance for 2008 was $455 billion, while in the prior three years prior it had exceeded $1 trillion.

These are some pretty large numbers. But it is a step in the right direction. Companies that were only able to function on the back of easy credit are not legitimate. Their shareholders should be wiped out and employees let go. That may sound heartless, but such an eventuality would enable another person to purchase the assets and redirect them toward a legitimate use, thus providing higher wages and a more useful product or service to someone else.

Speer says another trend is driving the lower numbers: the highest quality corporate credits aren't borrowing, choosing to fund business through working capital improvements or other forms of credit. "The companies that are borrowing are those that don't have a choice," he says. "That's why banks have to be that much more careful."
Why are changes to revolvers so important? The refinancing issues with revolvers affect more than just banking relationships, says Pam Krank, president of The Credit Department. For one thing, when a bank reduces or revokes a line of credit, "it's a trigger" for aggressive action on the part of unsecured trade creditors, Krank says. "If bank availability goes down, it makes the unsecureds very nervous." As a result, they cut the amount of trade credit granted a customer or put the customer on hold altogether, she says. "It has a huge impact."

Revolving lines of credit serve a legitimate economic purpose. They provide operating capital for businesses that have long periods between production and their eventual pay date. Futures markets serve a similar purpose for commodity producers.

However, like many other forms of legitimate credit, revolvers have been used for many purposes other than meeting such expenses with the naïve expectation on behalf of both banks and business owners that this revolver can simply be "rolled over" at the same rate forever. Share buybacks, factory expansions and even speculation on property markets were common recipients of these credit lines. Now that they're being taken away or having rates rise considerably, many of the malinvestments will require to be liquidated. In many cases, this will bankrupt the entire company.

The private debt markets are continuing to contract. And that is the single most important factor for the economy at this time. As such, I believe that the majority of my "Themes for 2009" will continue to play out as expected.

Deflation. Full steam ahead.

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occdude said...

You know I may be dating myself when I say that people used to comment that the only way to get credit is if you didn't need it. If you wanted a loan for anything, you put on a shirt and tie, polished your shoes and got your briefcase.

This whole "credit contraction" sounds just like traditional lending practices being employed again.

Matt Stiles said...

This whole "credit contraction" sounds just like traditional lending practices being employed again.

Fancy that, eh?

Anonymous said...

The hardest thing to predict in any of this mess is the timing of anything. Otherwise we'd all be rich uh.

Jon said...


I am an avid reader of both this blog and Dr. Keen's - clearly the two of you both see private debt levels as central to the current economic crisis... but, out of curiosity, which of his views do you not agree with?

Matt Stiles said...


They would be mere ideological differences. We would disagree over who deserves most of the blame for this current crisis and what path to take in order to avoid it in the future.

But as far as our analysis of the current position in the business cycle, we're in total agreement.


Charles-Philip Bentley said...

great post

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