June 26, 2010

Global Economic Contraction

The National Debt - a noose around our necks

The National Debt is strangling the economy, even as President Obama is calling for yet another Keynesian stimulus package. At $13 trillion, the National Debt is equivalent to 89% of the US GDP, and is likely to exceed GDP by 2012. As Professors Reinhart and Rogoff conclude in This Time is Different – Eight Centuries of Financial Folly, when debt exceeds 90% of GDP, growth is effectively cut in half. Once debt begins growing faster than GDP there is no way out, other than default or debasing the currency. Compounding interest payments, at projected higher interest rates, create a downward spiraling black hole which will lower living standards for all Americans for generations.

Defaults do not occur in a vacuum, but in series, like falling dominos. They result from expansionary fiscal policies which fail to adjust as the business cycle turns down, catching lawmakers off guard. This time they occurred after the downturn was well under way in attempts to turn the tide. Foolish stimulus packages have effectively mortgaged our futures, with virtually no lasting benefit. There's mounting evidence that the effects of horrendously costly stimulus are spent, these include: weak housing data, softer retail sales, and anemic private sector employment.

Dual policy goals: fiscal adjustment & intermediate-term growth

Now that the damage has been done, instead of attempting to force growth with additional stimulus, or cutting back drastically in “all out” austerity, we need to adapt twin policy goals of fiscal adjustment and intermediate-term growth as Mohamed El Erian, chief executive of Pimco, points out. These involve what emerging markets term “second generation structural reforms”, which enhance the longer-term responsiveness of western economies that have had their comparative advantages eroded. These twin goals involve long-term productivity gains and immediate help for those left behind. This means enhancing human capital by retraining parts of the labor force while increasing labor mobility. It would include infrastructure and technology investments with emphasis on those that promise the greatest incremental productivity. Of course this would involve politically unpalatable short-term pain for long-term gain, which is precisely what makes such reforms difficult to design and even harder to implement. While the world faces deep structural challenges in this mammoth Bear Market, its leaders are stuck in a short-term myopic mindset. But without such long-term perspective we can count on a future of continued global economic contraction and periodic sovereign debt crises. Its no wonder the 1stQ GNP has been twice revised downwards from 3.2% to 3% to 2.7%. Obviously stimulus has worn off....

In the recent swap, Argentina effectively paid 25 cents on the dollar for defaulted 2001 debt. Such punishing “haircuts” for creditors will certainly make them think twice about extending future loans to “financially shaky” sovereign states.

Unlike post-WW II, the last time we were this deep in hock, spending cuts are not so easy now. With 60% of the budget going to Medicare, Social Security and other welfare programs, shrinking the deficit, according to Clint Stretch of Deloitte & Touche, would require the elimination of virtually all entitlements. Yet spending cuts alone will not solve the problem, they must be accompanied by politically unpopular tax hikes.

Bank Lending

Western companies are trying to reduce leverage and their dependence on banks as fast as they can, in order to get around banks, which have cut way back on lending. One reason why corporate cash is at an all-time high is to reduce reliance on the banks. Yet companies de-leveraging are not likely to boost demand, or support growth. While large companies may be able to cope with the squeeze in bank lending for the time being, small companies cannot tap capital markets. As I discuss below, the days of being able to issue low-interest bonds are likely numbered, even for large AAA corporations. The outlook for smaller companies, which have already been shut out, is far bleaker.

Flight to dollar safety akin to aggressive monetary easing

Fiscal austerity in Europe, on top of a weak Euro make the prospects for US exports far worse than they were just two months ago. Thus, US manufactured exports will certainly not be the engine for job creation, nor can we expect their increased earnings to bail out a sputtering economy. Meanwhile the illusionary flight to “dollar safety” has brought intermediate and long-term Treasury yields down substantially, something the Fed could never have done. In turn, real interest rates on mortgages and business loans are at all-time lows - for those few who still qualify. In effect, similar to an aggressive monetary easing, thanks to the European turmoil. What's more, we would need for employment pick up substantially before any hints of inflation would start to appear. Essentially, with fifteen million Americans unemployed and the figure still climbing, inflation in the foreseeable future is pure illusion. Although the Fed termed it “underlying inflation is trending lower” that too is a euphemism for deflation. At 0.9%, inflation x-food and fuel, is at its lowest since 1961. Deflationary expectations become self-fulfilling, as major purchases are put off in expectation of lower prices, they become the driving force behind continual markdowns, necessary to move merchandise.

Sovereign debt risk the force behind equities, bonds & currencies

Bond vigilante's perception of US sovereign debt risk is the real danger now, and what will turn interest rates around dramatically, not inflation. At turning points, prices always make a head-fake, then turn around back the other way; this is precisely what we are seeing now in government bonds. While flight to dollar safety was synonymous with quantitative easing, its a two-edged sword, so too will dollar and Treasury bond flight choke off economic activity. Sovereign risk too is the force behind currency moves, as we have seen the Euro drop 12% since January, while Britain's austerity measures have managed to prop up the currency substantially. Of course the Euro is due at least a big bounce, while dollar is next in line for depreciation.

You will notice the daily dollar chart mimics the 10 min S&P chart identically. The downturn in stocks concurrent with a downturn in bonds and the dollar will compound the damage as foreign investors jump ship for sounder safe havens. The minimum drop in the dollar is ~73 on the index and likely exceeded by a wide margin.

The risk premium

Of course, with borrowing costs rising materially, rising interest rates would be a major drag on stock prices, and according to the Capital Assets Pricing Model, would indicate equities are highly overvalued. The risk premium, the amount over the “risk-free rate” of Government bonds that investors must earn to compensate them for owning stocks, is about to shoot up. The higher the rate, the cheaper shares need to be to provide the incentive to take on the added risk. While further stimulus looks highly unlikely, interest rates will likely go no lower. From here just a 1% rise in interest rates would likely cut at least 500 points off the S&P 500.

Below the hourly chart of inverse bonds, levered showing an a-b-c wave 2, where a Diag > also indicated the reversal in progress. The next upside is at least to 66. In other words, the point of recognition, where it becomes obvious that bonds are guaranteed losses. Wave 2 in inverse bonds below corresponds with wave ii in long bonds on the daily chart that follows, just form the opposite perspective.

David Rosenberg terribly wrong on bonds

While I agree wholeheartedly with David Rosenberg's prognosis on de-leveraging, deflation and the overpriced equity market, he is totally wrong on bonds. David seems to think that because US Treasury bonds are guaranteed, pay a dividend and are projected to decline by economists, it precludes them being in a bubble. It is that very guarantee that is being called into question, with tax receipts having regressed 30 years and declining, the only thing guaranteed about bonds is catastrophic losses. Rosenberg also seems to think that because only 6% of US assets are in bonds and expected to grow, that somehow insulates them. As we know, analysts’ projections are wrong at least 50% of the time, and since they invariably project in a straight line, rather than cyclically, they are always wrong at turning points. David further reasons that if the Japanese can get a away with a 200% debt-to-GDP ratio and 10-year bond yields remain at 1.2%, then surely the US can get away with 90% debt-to-GDP ratio and have interest rates continue to drop in similar fashion, while bonds appreciate. But all that occurred before Greece and the entire sovereign debt crisis. Going forward Japan will not likely not have it so easy, yet their creditors remain largely domestic, while our lenders are mostly foreign, namely China and Japan. It is neither inflation nor deflation that will move interest rates going forward, but the likelihood of default that will drive up interest rates to compensate lenders for the incremental US sovereign risk. The long bond charts indicate US Treasury bonds are certificates of guaranteed confiscation. (worse are municipal bonds and junk corporates of course)

In the daily long bond chart we see a bounce in wave ii complete to just a hair below par (it cannot exceed the high of wave iv, of the Diag II) from here a long move down. To refresh your memory Diag II indicates the beginning of a major decline, the bigger the structure the larger the proportional decline. The one below spanning six months on the daily chart is not to be taken lightly with an absolute minimum plunge to 87 from roughly 99.5 just last week, for a13% plunge.

Collapsed Debt Market

In the last decade securitization expanded at an astounding pace, where securitized market represented more than half of all credit creation in some sectors. By 2007 Citibank estimates there were $8,000 billion worth of assets funded by securitization. Last year there were just $4 billion of worth of collateralized debt obligations (CDOs) created, versus $520 billion in 2006. By default, Central Banks have become the source of securitization. Take for example the gargantuan $1,250 billion of mortgage-backed securities which the Fed has purchased - these are merely camouflaging a gaping hole in credit creation. Sales of CDOs to private investors, who previously bought 95% of securitized products, have dried up. If real investors re-emerge, they will demand much higher returns. Of course that means a smaller market going forward. Either central banks continue to replace the securitization market indefinitely, (unlikely) or they must adjust to credit that is far more scarce and costly and by extension economic contraction rather than growth.

China

While Chinese inflation recently hit a 19-month high, that too is but a head fake. Just like in 2008, when markets went into a tailspin, inflation was virtually snuffed out overnight with the collapse of the Chinese stock and real estate markets. When trillions of Renminbi wealth vanish into thin air, so does inflation. Inflation after all stems from a sharp increase in the money supply where too much money is chasing too few goods. We can expect more the same carried over to all inflation-prone Emerging Markets.

FXP is not behaving well and we will exit all positions limit 37.38.

Although the daily chart below shows a turn around there is still some downside left

Freight Rates

Container shipping rates are seen as a barometer for global economic growth. Like everything else, they took a beating in the depths of the downturn last year. Until last month these had bounced back energetically, with spot rates on key trade lanes up 60% on the year. Only a month ago, Asian route revenues appeared headed to exceed 2008's records this year, (projecting in a straight line as usual) while non intra-Asian routes were expected to drop off by double digits. Here again, another deceptive head fake in intra-Asian commerce, already reversing with the cost of the largest Capsize vessels, used to transport iron ore to China, falling below the level of Panamax vessels, less than half their size. The Baltic Dry index (BDI) of freight costs has dropped 40% from a month ago to 2,502 on last Thursday. With record growth in fleet supply coming on line in the second half of the year, while China continues tightening, can only mean record low shipping rates and much idle capacity, consistent with the global economic contraction.

Inventory De-stocking

What is most striking is that freight rates have recovered without the usually correlated rise in inventory in the US as a percentage of sales and in US housing starts. There has never been a bout of such extreme de-stocking. After 15 drops in 16 months it is well below the previous 30-year low. Yet this time it's Depression that's lurking in the guise of Recession. Of course that's another reason why corporations are awash with cash.

Double-Dip Housing Market

In May, new residential home construction fell by 10%, a much bigger plunge than was expected with the end of the tax credit. In the South, housing starts were down 20%, twice the national average. While analysts expected a 7.5% rise in closed contracts in, they actually fell 2.2% last month, as potential buyers ran into problems closing. It would appear that the tax credit brought demand forward, while failing to stimulate additional sales. Sales of new US homes slumped by a record 32.7% in May, the lowest level since records began in 1963 and prices fell to the lowest since 1963. What's more, a large drop in existing home sales was reported on Tuesday. Housing starts would need to double for this to be considered a normal recession. Government backed mortgage agencies namely Freddie Mac and Fannie Mae already make below market loans. Considering that a one percentage point increase to market rates on the typical a 30-year $150,000 mortgage implies a subsidy of $33,000 over the life of the loan, and amounts to four times the expired first-time homebuyer credit. That's in addition to the substantial mortgage interest tax deduction subsidy.