elements like major terrorist attacks or natural disasters, I believe six
phenomena are shaping the investment climate this year. The world is awash
in financial liquidity mainly due to rising house values, the negative US
corporate financing gap and the American balance of payments deficit.
Inflation remains low despite higher energy prices. As a result, investment
returns are low. Speculation remains rampant despite the
2000-2002 bear market. So, investors are accepting more risks to achieve
expected returns. And then there's the insatiable US consumer, who, thanks
to the booming housing market, continues to spend freely.
In this climate, I foresee 12 investment themes, seven of which are likely
to unfold in 2007 while four will probably work but maybe not until next
year:
1. Housing prices will collapse. The housing bubble is deflating as sales of
new and existing homes slide, prices begin to drop and housing starts
decline. A bigger price plummet may start soon as many speculators give up
on appreciation dreams and throw their properties on the market, triggering
a downward spiral.
Alternatively, interest rates on the Adjustable Rate Mortgages of many
subprime borrowers will adjust up dramatically this year and force them into
defaults and house sales.
Cheaper energy costs will not offset losses in house appreciation nor will
non-residential construction growth. The Fed is unlikely to slash interest
rates soon enough and big enough to save the day. Washington will be
politically forced to bail out hapless homeowners, but as with the late
1980s-1990s S&L crisis, will probably arrive too late to prevent major
damage.
The boom has largely been driven by investors' zeal for high returns, ample
cheap mortgage money and lax lending standards. Unlike earlier US housing
booms and busts that were driven by local business cycles-such as the rise
and fall of the oil patch along with oil prices in the 1970s and 1980s-this
one is national and, indeed, global. And since houses are much more widely
owned than stocks, the bubble's likely demise will shake the economy more
than the earlier bear market in stocks.
2. The Fed will ease when house prices collapse.
Meanwhile, the yield curve will remain inverted. Once the Fed embarks on an
interest rate-raising campaign, it almost always keeps going until something
big happens, and that something is normally a recession. Such a campaign
clearly started in June 2004. This time, we're betting that the bursting of
the housing bubble beats the Fed to the punch, but if not, the central bank
will, as usual, do the recessionary deed. Once housing is in a shambles,
either falling from its own weight as we expect or due to central bank
action, the Fed, of course, will patriotically ease as the economy hits the
skids.
The yield curve inversion, the only meaningful effect of the Fed's current
campaign that we can find, rightfully worry many because they have preceded
every recession since 1950 with only two fake signals. Today's
rationalizations as to why long Treasury yields are artificially depressed
appears no more valid than those in early 2000 as the yield curve neared
inversion. The federal surplus at the time resulted in few new Treasury bond
issues. That, the optimists believed, was depressing Treasury yields and
causing a false recession-forecasting signal. But the 2001 recession
followed the inversion, as usual.
3. US stock prices will fall, perhaps below the 2002 lows, in the midst of a
major recession. A major decline in housing prices and activity will almost
surely precipitate a full-blown US recession. That, in turn, will send
corporate profits down after a spectacular advance over the last five years.
Without this robust growth, stocks are vulnerable.
4. China will suffer a hard landing due to domestic cooling measures and US
recession. China is attempting to cool her white-hot economy, which grew at
an estimated 10.5% rate last year, but is having difficulty.
Fundamentally, China is experiencing a capital investment bubble, which is
very misleading even in open market economies since is sends the wrong
signals to participants. Since it takes capacity to build more capacity,
what looks like strains and shortages are really symptoms of mammoth excess
capacity problems that are only revealed when the boom subsides.
That's what happened in the US new tech boom in the late 1990s, and now in
China in less sophisticated industries. That excess capacity will, of
course, drive even bigger exports.
A major US recession will shrink Chinese exports dramatically as US
consumers buy less of everything, especially imports. Indeed, as US
manufacturing shifts to China, so does its inherent volatility and inventory
cycles-and the long shipping time between China and the US enhances those
cycles' violence. So between domestic economic cooling measures and a US
recession, a Chinese business slump is in the cards for 2007.
That, of course, doesn't mean an actual decline in real GDP in China. A cut
from the current 10% growth rates to 4% or 5% would be severe since more
than that growth rate is needed to employ the hordes that continue to stream
from the hinterland to the coastal cities in search of better jobs and
lives.
5. Weakness in US and China will spread globally, dragging down economies
and stocks universally. The US economy dominates the world, not only because
of its size but also because America is the only major importer. Most other
countries are running trade surpluses, and the US is the buyer of first and
last resort for their excess products. The Chinese economy is closely linked
to America's, as just discussed, and a US recession combined with Chinese
domestic economic restraint measures insure a global downturn. Other major
economies in Japan and Europe simply can't pick up the slack.
6. Treasury bonds will rally. Yields rose a bit over the last year, but
surprisingly little in view of continued economic growth and further Fed
tightening. This tells me that global deflationary forces are robust.
Downward pressure on Treasury yields will result when the Fed reverses gears
and eases once housing is clearly in retreat and a recession is evident. I
expect the current 4.7% yield on the 30-year bond to decline in
2007 and ultimately reach my long-held target of 3% when deflation becomes
irrefutably established.
7. The dollar will rally, but only after the recession becomes global. The
greenback last year remained string against the yen but not against the
euro. Of course, the global recession that will make the buck a safe haven
is yet to unfold. Meanwhile, with the US likely to be the first major
economy to slump and the Fed the first major central bank to cut rates, the
dollar may be weak early this year. Strength would come later in the year as
US consumers curtail spending, imports fall and, as a result, foreign
economies become weaker than the US
Later this year, the dollar should gain against the euro and yen and also
against the commodity currencies-the Canadian, Australian and New Zealand
dollars-which will suffer as global recession slashes commodity demand and
prices. Emerging countries' currencies will also suffer in global recession.
8. Commodity prices will nosedive. Commodity prices have shown unusual
strength in recent years. And the robustness has not just been in the energy
sector, but spread broadly. Industrial metals prices have skyrocketed. So
has livestock and grains of late. Even precious metals have reached prices
not seen since inflation was raging in the late 1970s.
In the long run, we don't see any constraints that will prevent the normal
reaction to high commodity prices- increased supply that will depress
prices. In energy, the Hubbert's Peak devotees believe the world is running
out of crude oil so prices will skyrocket in the years ahead. But we're
convinced that human ingenuity will, as in the past, prevent a Malthusian
outcome. The ongoing fall in US home sales and likely collapse in prices
will have very negative effects on the prices of building materials such as
gypsum and copper. Lumber prices have already nosedived. And copper prices
are already at a nine-month low.
9. Maybe global and chronic deflation will commence in 2007. With a global
recession collapsing commodity prices and the robust deflationary forces
already at work, major goods and services price indices here and abroad,
such as the CPI, will fall this year if a global recession unfolds. But that
doesn't guarantee chronic deflation. Inflation usually recedes in
recessions, so it's the action in the following recovery in 2008 that will
tell the tale. If price indices continue to fall then, true deflation will
have arrived.
10. Maybe US consumers will start a saving spree, replacing their 25-year
borrowing and spending binge.
The money extracted from, first, stocks, and more recently, from houses are
behind the drop in the US consumer saving rate. Just like the falling saving
rate, the rising debt and debt service rates can't continue forever. With
stocks likely to again fall significantly, a significant fall in house
prices seems almost certain to precipitate the monumental shift from a
quarter century borrowing-and-spending binge to a saving spree- unless
another source of money can bridge the gap between consumer incomes and
outlays. But no other sources such as inheritances or pension fund
withdrawals are likely to fill that gap.
With no remaining alternatives, and with baby boomers needing to save for
retirement, American consumers will be forced to embark on a long-run saving
spree, although clear evidence of a chronic saving binge may be postponed
until after the forthcoming recession.
11. Maybe deflationary expectations will become widespread and robust.
Deflationary expectations spread and intensified in 2006 as consumers waited
for lower prices for cars, airline tickets and telecom fees before buying.
Christmas 2006 sales depended heavily on slashed electronic gear prices.
When consumers wait to buy, producers are left with excess capacity and
inventories that force them to cut prices. Those cuts only fulfill consumer
expectations and encourage them to wait for even lower prices.
"Maybe" those expectations will leap this year because "maybe" widespread
and chronic deflation will be recognized. If so, then buyers will wait for
lower prices, and vigorously so in many more product areas.
12. Speculative areas beyond housing may suffer in 2007.
Housing is not the only area of heavy risk-taking. It just appears to be the
most vulnerable. A Great Disconnect between the real economy and the
speculative financial world has existed since the late 1990s. It's been fed
by mountains of liquidity sloshing around the world, expectations of and
demands for oversized investment returns, and low volatility, all of which
have encouraged risk taking. Anticipated stock volatility remains at rock
bottom. Spreads between yields on junk bonds and Treasuries are tiny as
ample financing and loose lending keep corporate defaults at record lows.
The huge gap between speculative financial markets and economic reality has
persisted for a decade. It will probably be closed with many tears in the
next recession, only adding to its depth.
*** One helluva show...a chump, a patsy and a stooge...
*** Dear Gordon...a Bank of England exclusive...
*** Living paycheque to paycheque...on the edge of technical
insolvency...nominal savings...and more...
Bill Bonner, from the wet streets of Southwark:
Do you have your eyes open, dear reader? Well, look carefully, because what
you are seeing is one helluva show.
Unfortunately, it is likely that we are only in the middle of it. And
unfortunately, it is almost surely a tragedy. When the fat lady finally
sings, there are going to be a lot of people with tears in their eyes.
But we are getting ahead of ourselves...
Every great public spectacle turns mass man into a chump, a patsy and a
stooge. He gets sent off to fight and die in wars that are of no real
importance to him.
He gets caught up in the delusions of politics, joins a lynch mob, or
watches TV and wonders what Paris Hilton eats for breakfast. Or, he is
ruined in market crash, inflation, or depression.
It is all very well for wealthy speculators to be ruined. They usually
gamble with money they can afford to lose. But in this last go-round, the
average fellow put everything he had on the table. Without realizing it, he
speculated with the family home.
There was more to it than that, of course. What we are seeing is really a
massive transfer of wealth; the biggest transfer ever. You see, what drew
the average man into the mortgage market was the lure of getting something
for nothing. Without lifting a finger, his house rose in price. He looked
and thought he saw free money. He could 'take out' this extra wealth and
still have as much equity in his house as he began with. He felt he was
actually getting richer; so why not spend a little more.
The catch was that he wasn't really getting richer at all. That is the
curious thing about a boom fueled by asset price increases. They do not
really make people, generally, richer. Instead, they make SOME people
richer.
You already know who those people are, don't you, dear reader? We have
mentioned them often in these pages.
They are the lucky 1% of the population who have substantial assets...and
the few hundred thousand who work in the financial industry. Hedge fund
managers, investment bankers, substantial property owners, people who own
art and antiques, even people who own stocks.
Most US stocks are less valuable, in real terms, than they were 7 or 8 ago.
But they are a lot more valuable than they were 20 years ago.
For the first time in history, the rich really are getting richer at a rapid
pace. Here's how it works. The world's central banks, led by the US Federal
Reserve, and other financial intermediaries, create new forms of 'wealth' -
paper dollars, securitized debt, derivatives, etc. Bond issuance, for
example, has doubled in the last
6 years. Derivative creation has soared over $300 trillion. This 'wealth'
never seems to reach the hands of the masses. Instead, it stays with the
investing classes - bidding up prices on financial assets and other forms of
wealth favored by the rich (such as London houses and works of art by people
without talent). In other words, a new form of 'inflation' has been loosed
upon the world, one which everyone seems to love. It boosts the wealth of
the wealthy, spectacularly.
According to a new study by McKinsey and Co., the value of all the world's
stocks, bonds and other assets has ballooned to $140 trillion. These assets
are traded across international borders. And they are growing much faster
than the real economy that supports them. There you have the fundamental
difference...and the theme that runs through this whole farce. A company may
produce $10 in profits, growing at a rate of maybe 5% per year. But the
loans, stocks, bonds, and derivative positions based on this company's
output are growing at twice the speed.
The average person works in the real economy. If he is lucky, he could see
his wealth grow along with the growth of the real economy. But the people
who own financial assets are watching their wealth grow much faster.
Wait, how is this possible? The real wealth of the economy depends on the
real output of its real businesses. That is where the goods and services are
produced. Trading, speculating, lending, acquiring, buying-back, refinancing
- these are just peripheral activities that have no direct bearing on real
output.
So, how can it be that one segment of the society, a very small segment at
that, is getting so much richer than the growth of real output?
Ah! There's the slick, tragic, disastrous side to this performance. It is as
if the central banks had printed up huge quantities of additional dollars,
and instead of distributing these to the economy at large, it gave them only
to the rich. Thus, the rich gain the benefit of the inflation; their
purchasing power rises dramatically.
But the rest of the population suffers it; their own purchasing power
declines. They have no more income, while they have both higher living
expenses; health care, housing, energy and education have all gone up
sharply. And to make matters worse, they now have to pay off the money they
borrowed when they thought they were getting rich.
Stay tuned, dear reader. This spectacle is bound to get even more
interesting...
And now over to - oh! - Mervyn King at the Bank of England on Threadneedle
Street...
---------------------
"Dear Gordon,
"Hope this finds you, Sarah and the boys well. Happy New Year by the way.
"How's the house-move going? Sure you won't have to wait too much longer. At
least you won't have to pay stamp duty when next door finally clears out!
"Now look, the reason I'm writing is that, well, you know how - at the
Election last spring - you said mortgage rates were at a 40-year low. And
you also warned the voters not to let the Tories take us back to 15%
interest rates.
"Smart move by a smart Chancellor, as always. The electorate fell for it
hook, line and sinker! But there's no easy way of saying this, Gordon -
inflation just hit a 15-year high. I think the game might be up.
"That's why we raised base rates last week. To fight the good fight, you
see, and keep prices stable, just like you told us when you made the Bank
independent (another smart move - you'd make a great tactical football
manager. God knows Aston Villa could do with some help!).
"Trouble is though, even at 5.25%, base rates are now paying just 0.6% above
RPI. Yes, I know - we should ignore the old inflation measure, just like we
agreed, and stick with the CPI instead. But it's January, Gordon. Pay rounds
for 2007 are in full flow, and with you still linking state pensions to the
RPI, the bloody Statistics Office just gave the unions a new stick to beat
the employers with.
"If wage levels take off from here, we're both for the high jump. All those
cheap goods imported from China over Christmas won't keep the lid on
inflation - not if everyone starts clamouring for more pay.
"Then there's the savings rate. You see, after tax, even basic-rate tax
payers are losing money at the banks now.
Their savings are shrinking, not growing! Ask Ed Balls to do the maths if
you don't believe me.
"Last time real interest was this bad, we'd just slashed base rates to that
50-year low you were so proud of. But look at the trouble cheap money's
caused us now! So please, don't get too cross if no one stops spending and
starts saving just yet. The extra debt might help prop up house prices a
while longer. But if property values don't keep pace with inflation this
year, it could be the early '80s all over again. And not even Villa winning
the league would make up for 3 million on the dole.
"Fact is, we've got no control over the UK credit markets anyway. Paul
Tucker went and let the cat out the bag in a speech last month. He's in
charge of Markets here at the Bank, so I thought I could trust him not to
shoot off his mouth. But just like he said in December, big changes in
banking mean we can't even measure liquidity and money supply anymore. The
City's in charge.
"You might have read about it in The Daily Reckoning last week (a few of
your chums in the Cabinet Office receive it I hear). The broad money supply
numbers just don't add up. It's all to do with derivatives and
mortgage-backed bonds - Northern Rock's floated half of its lending book on
the bond market, for instance. So whatever we do to rates, the bank can just
borrow fresh money abroad.
"Hell, Northern Rock's senior management just did a road show in the US,
flogging more of their UK mortgage- backed bonds! Two-thirds of their bonds
are already priced in US dollars, and now Northern Rock's growing its
lending by 20% year on year.
"If you want my advice, Dear Chancellor, you might ask Uncle Alan to call
Ben Bernanke in Washington and see if he can't do something to help us out
of this hole.
Heaven knows they owe us a favour after helping to fix the stock market with
cheap money since 2003.
"We've still got a bit of time to play with yet. This month's post-Christmas
sales should put a dent in the next set of CPI numbers. If not, you'll have
to strong- arm the Statistical mob in Cardiff I'm afraid. I really don't
want to have to write you an open letter, explaining who got us into this
mess.
"The gilt markets think we're home and dry too, poor mugs. The price of your
government bonds actually rose yesterday, pushing gilt yields down (again,
ask Ed Balls if you don't get it). So you might want to knock out a few
50-year bonds quick. Because let's face it, Gordon - all that cheap money
we've spewed out has come home to roost. Base rates are going to have to
shoot higher. I said it all along.
"Look, I know you hate being compared with Lawson or Clarke. But last time
inflation was this bad, base rates in Britain were 10.38%. Now they're
barely half that price! Yes, back in Dec. 1991 we were defending the Pound,
just before that Hungarian character got us thrown out of the Eurozone
system. Today sterling's at near-record highs. But this won't stop the
proverbial hitting the fan this year.
"Like the pound and economy, we're on borrowed time here. Sorry I haven't
got better news for the New Year.
"Best as ever, Mervyn"
(as told to Adrian Ash of BullionVault.com...)
---------------------
And more views from Bill:
*** Colleague Byron King:
"Household savings are a variety of endangered species, certainly for most
working-class Americans. But not to offend the working class, the middle &
upper-middle classes are falling into the same category as non- savers. Most
US households have no current savings plan.
None. Zip. Nada. Most US households live paycheque to paycheque, and most
households are constantly on the edge of technical insolvency. Lost job,
illness, divorce, sudden financial hit...most households will be pushed over
the edge. This is as true in the leafy, McMansions of the McSuburbs and
ex-urbs, with their well-coifed soccer moms and well-shod hockey-dads, as it
is true in the rows of urban and near-suburban tract houses in which dwell
the blue-collar workforce of the nation (or what is left of it).
"And of those US households that do 'save money,' the vast majority have
only nominal savings. Many people who try to save really don't know what
they are doing. They will put $100 in a passbook savings account at 2.2%,
but still carry credit card debt at 24%. Nobody has ever explained to them
the difference, or advised them how to do it better. Best figures are that
close to 50% of US households have negative net-savings (even excluding
mortgage debt). With housing loan debt included, something like 70% of US
households (homeowners and renters in total) have a negative balance sheet.
(OK, so they 'own' a house with some equity and a mortgage. If housing
prices decline 20%, then they are in negative
territory.) One US bankruptcy trustee put it to me this
way: 'More US citizens are net in-debt, than voted in the last presidential
election.'"
Doesn't say much for either US financial habits or political trends.
"Most households are busy paying daily bills, and past debt. This uses up
essentially all income. It is a situation of, as the saying goes, 'too much
month left at the end of the money.' So it is no wonder that there is so
little (or nothing) left over to save.
Was it Warren Buffet who coined the phrase 'sharecropper society?'
"We are there."
*** Yes, we did it again. We mixed up 'lebensraum' with 'liebensraum.' When
will we learn German? On the other hand, we like the error...it reminds us
of the time we went to a restaurant in Italy and ordered spaghetti with a
policeman on top of it (carabinieri, carbonara; anyone can make that
mistake). Hitler said Germany needed 'lebensraum'(living room), not
'liebensraum' (loving room). If only Hitler had made the same mistake, how
the history of the 20th century might have turned out differently!
*** We got soaked walking to our London office this morning. It often rains
in England, but even the English were not prepared for a downpour.
"It usually doesn't rain like this," explained an English friend. "It
usually just sweats. But the climate is changing, isn't it?"
Maybe it is. Today's International Herald Tribune tells us that the glaciers
are receding so fast in Greenland that mapmakers can't keep up with it. As
the ice melts, new islands are discovered.
*** We are all victims of technology. We've had our car for a couple of
years. We still can't figure out how to turn the radio off. And this
weekend, we spent a night in a hotel with all the latest gadgets. In the
bathroom, for example, a toilet had visible tank and no flush handle.
Instead, it had an electronic eye. You simply passed your hand in front of
it, and the toilet flushed.
The trouble was, the mechanism on the inside must have been old technology,
for after flushing, water kept running in the bowl. Normally, we would
jiggle the handle in such a case. If this failed, we would reach down into
the tank to jiggle the mechanism directly. But there was no handle to
jiggle, no tank to open up...and no plumber on duty Saturday night. The
toilet just ran.
*** Oh, and today's news brings both good and bad tidings to Americans
overseas. On the bad front, the world has gotten to be very expensive for a
man who earns dollars. The cost of a London office, for example, has zoomed
to $212 per square foot per year. The last time we looked our cost in
downtown Baltimore was under $20.
But, the good tiding is that at least we will be aware of the cost longer.
Here is a report from Reuters:
"People who are fully bilingual and speak both languages every day for most
of their lives can delay the onset of dementia by up to four years compared
with those who only know one language, Canadian scientists said on Friday."
"The Alzheimer Society of Canada described the report as exciting and said
it confirmed recent studies that showed that keeping the brain active was a
good way to delay the impact of dementia.
*** And now, an email making its way around the internet, finds its way to
us and to you:
"This is dedicated to those born 1930-1979
"To All the Kids Who Survived the 1930s, 40s, 60s, and 70s!
"First, we survived being born to mothers who smoked and/or drank while they
were pregnant. They took aspirin, ate blue cheese dressing, tuna from a can,
and didn't get tested for diabetes.
"Then after that trauma, we were put to sleep on our tummies in baby cribs
covered with bright colored lead- based paints.
"We had no childproof lids on medicine bottles, doors or cabinets and when
we rode our bikes, we had no helmets, not to mention, the risks we took
hitchhiking.
"As infants and children, we would ride in cars with no car seats, booster
seats, seat belts, or airbags. Riding in the back of a pick-up on a warm day
was always a special treat. We drank water from the garden hose and not from
a bottle. We shared one soft drink with four friends, from one bottle and no
one actually died from this. We ate cupcakes, white bread and real butter
and drank Koolade made with sugar but we weren't overweight because we were
always outside playing. We would leave home in the morning and play all day,
as long as we were back when the streetlights came on. No one was able to
reach us all day. And we were ok.
"We would spend hours building our go-carts out of scraps and then ride down
the hill, only to find out we forgot the brakes. After running into the
bushes a few times, we learned to solve the problem. We did not have
Playstations, Nintendo's. X-boxes, video games at all, no 150 channels on
cable, no video movies or DVD's, no surround-sound, CD's or Ipods, no cell
phones! No personal computers, no Internet or chat rooms. WE HAD FRIENDS and
we went outside and found them!
"We fell out of trees, got cut, broke bones and teeth and there were no
lawsuits from these accidents. We are worms and mudpies made from dirt and
the worms did not live in us forever.
"We were given BB guns for our 10th birthdays, made up games with sticks and
tennis balls and, although we were told it would happen, we did not put out
very many eyes.
We rode bikes or walked to a friend's house and knocked on the door or rang
the bell, or just walked in and talked to them!
"Little League had tryouts and not everyone made the team. Those who didn't
had to learn to deal with disappointment. Imagine that! The idea of a parent
bailing us out if we broke the law was unheard of.
They actually sided with the law.
"These generations have produced some of the best risk- takers, problem
solvers and inventors ever!
"The past 50 years have seen an explosion of innovation and new ideas. We
had freedom, failure, success and responsibility, and we learned. How to
deal with it all.
"If YOU are one of them...CONGRATULATIONS
"You might want to share this with others who have had the luck to grow up
as kids, before the lawyers and the government regulated so much of our
lives.
"For our own good."
No comments:
Post a Comment