January - 2009 Economic Brief

Good news!

To those of you who have been following my economic surveys since March 2008 you will be happy to learn that I have a New Year’s resolution - to be brief, and not include so much documentation and/or references. These commentaries represent a mélange of newsletters, CFA resources, media and my own spin. For specific reference, ask me directly. So what follows is in summary format...

More good news because of bad news

The U.S. trade deficit has narrowed substantially; our trade deficit fell to $40.4 billion from $56.7 billion. Such an improvement in the U.S. trade deficit means that dollars aren't leaving to flood other overseas investments. In fact, they're coming back to our shores ... a sure argument for why the U.S. dollar is in a position to appreciate ... despite the global recession. That's why I remain bullish on the U.S. dollar, short-term. Ultimately inflation will re-inflate almost all tangible assets, and the chief beneficiary... gold anyone? (See March and April’s 2008 postings for more on this.)

Further, the monetary base was increasing at 3-4% per year through September 2008, nice and steady.

But then it kicked into overdrive and accelerated to a mind-blowing 990.9% annual rate for the three months ending. And, if averaged out, that's an annual increase of 86%. All this will tend to push the market to rally some and volatile it will be.
The name of the game for 2009 is going to be avoiding losses. A Treasury-only money fund gives you immediate availability to your money. You can have your funds wired to your local bank overnight. And you can even write checks against it, much as you'd write checks against any bank checking account. That’s the end of the good news.

What happened?

The entire safeguards system, consisting of disclosure, regulation and supervision failed. The point at issue is the Glass-Steagall Act – passed in 1933, in response to the Wall Street crash. It prevented commercial banks – which take deposits from ordinary households and firms – from engaging in high-risk speculative activities undertaken by investment banks. Or at least it did until 1999 when, it was repealed by President Clinton. One of the main proponents of scrapping Glass-Steagall was Clinton's Treasury Secretary Larry Summers. Despite his key role in enacting this historic blunder, Summers is to be Obama's chief economic advisor. Go figure? James Wolfensohn, the former president of the World Bank said, it is "not the system; the system did not drive it... (it happened) because individuals took advantage in the absence of appropriate regulation." This month, the Congressional Oversight Panel is reporting that the U.S. Treasury is doing nothing, including failing to properly track the hundreds of billions of dollars it doled out in bailouts (referring to TARP - Troubled Asset Relief Program). The more things change, the more things remain the same.

Treasury Secretary Paulson said, "In the years leading up to the crisis, super-abundant savings from fast-growing emerging nations such as China and oil exporters... laid the seeds of a global credit bubble that extended far beyond the U.S. sub-prime mortgage market and has now burst with devastating consequences worldwide... investors looking for yield, missed pricing risk.” So, massive levels of new, exotic derivatives (mortgage-backed securities) funded by emerging countries’ savings is one of the core reasons for the lack of U.S. consumer savings and the global crisis. This has been confirmed, says the Organization for Economic Co-operation and Development, who have said that the crisis in the US started to really surge beginning in 2004 with investment in residential mortgage-backed securities. The European banks invested this new money in Eastern Europe, Spain and the UK invested like the U.S. into a housing bubble, and Japan’s banks continued to invest more and more into their own equities.

What’s happening now?

A new phase of the bank crisis is beginning ... soaring unemployment, plunging stocks, canceled dividends, and sinking investment income is ahead.

Robert Shiller, professor of economics at Yale University, said the U.S. economic downturn "is no ordinary recession", the problems are much worse.

The U.S. economy is in trouble. And it could get much worse for the U.S. as unemployment seems set to shoot higher. But, it's all relative to the rest of the world. And relative to the potential for a lot more pain elsewhere. Still, consider that the U.S. financial assets could surprise investors, meaning: expect a lot of volatility.

Retail:

Expect thousands of store closures, reeling from the worst falloff of US holiday sales since the 1970s. Industry experts said the economic downturn is not following patterns seen before, and consumers may be in the process of changing their spending habits permanently.

Stock market:

Last year's 32% decline in the stock price of Warren Buffett's Berkshire Hathaway was the worst fall in more than 30 years but still better than the 39.8% drop of the S&P 500 or the Dow Jones Industrials, which has lost 33.9% since January 1, 2007 or the Nasdaq which lost 35.49%.

Call it what you want: depression or recession, but factor in a 24 month contraction, given the circumstances. I remind readers that Ronald Regan defined recession as when your neighbor loses his job and a depression when you lose yours. Note that the P/E ratio of the S&P 500 based on trailing reported earnings for 2008 is 19, which is not cheap because Bear markets tend to end with trailing P/E ratios in single digits, so we still have lots of room to move.

On the other hand, and in consideration of the expected market volatility going forward, we could get a rally lasting a few more weeks to a few months (see chart http://www.spearreport.com/update/1.2.09_Dow.gif.). The last three times the Dow was this oversold, which occurred in the 1970s, the market rallied for 6-8 months.

Commodities:

Commodities in 2008 posted their worst performance in history.

Manufacturing:

The Institute for Supply Management's (ISM) factory index tumbled from 36.2 in November to just 32.4 in December, the lowest level since June of 1980. The all-time low for this data series, which began in 1948, was 29.4 in May 1980.

Industrial Production:

Ford and General Motors, for example, are down more than 90% from their peaks. Industrial production dropped by a bigger-than-expected 2 percent in December.

Financials:

Bank of America has fallen 68%. Bank of America posted its first loss in 17 years — a whopping $1.7 billion and cut the dividend it pays to stockholders. Bank of America has been given a $138 billion rescue package that matches that given to Citigroup. Citigroup’s total losses for the year are a staggering $18.7 billion, including a $8.29 billion loss for the fourth quarter.

State governments:

The number of states facing urgent fiscal difficulties has suddenly surged to at least 45. The Center on Budget and Policy Priorities (CBPP) projects that their combined deficits will surge to $350 billion.

City Governments in Even Worse Shape:

Cities are typically unencumbered by the legal requirement to balance their budgets. In New York City the New York Independent Budget Office is now pegging it’s deficit at $11.3 billion. In California, the biggest borrower in the municipal market has torn a $42 billion hole in the state’s budget. This scene, repeated across the nation, could create a whopping $100 billion in new municipal deficits on top of the $350 billion in deficits at the state level.

Grand total: $450 billion in red ink flowing from state and local governments ...

Real Estate:

More than 861,000 homeowners lost their houses to foreclosure in 2008, and filings surpassed 3.1 million.

Pension Funds:

The consulting firm Mercer recently estimated that the pension funds of big U.S. companies are underfunded to the tune of $409 billion! This could also lead to reduced business investment as companies are forced to divert money from equipment and facilities budgets to their pension funds.

Federal Home Loan Banks:

After the federal government, they’re the biggest borrowers in the country. Moody’s recently warned that eight out of the 12 FHLBs could ultimately face capital problems thanks to losses on their $76 billion of mortgage securities not backed by Fannie Mae and Freddie Mac. While many investors have never heard of the FHLBs, they collectively have roughly $1.25 trillion.

US Federal Government deficit:

Add to this an estimated additional $1.186 trillion deficit at the federal level for 2009 plus the latest woes of the nation's megabanks and all in the midst of a collapsing economy! And, by the way, how much is that? That’s more than the inflation-adjusted cost of the Vietnam ($698 billion) and Korean Wars ($454 billion). It makes last year's $455 billion deficit look like chump change. The projected 2009 figure is equal to about 8.3% of U.S. GDP. Further, the Budget and Economic Outlook for Fiscal Years 2009 to 2019 (available at: http://www.cbo.gov/ftpdocs/99xx/doc9957/01-07-Outlook.pdf - see page 23), projects red ink as far as the eye can see: An additional $3.135 trillion from 2010 through 2019. WOW!

Add to this:

The more than $70 TRILLION in debts Washington already has incurred during the “good” economy that is comprised of the more than $10.6 trillion in national debt... plus the $58 trillion in unfunded Social Security obligations and Medicare.
And this is all before Obama’s estimated $1.2 trillion in fiscal stimulus programs coming... to once again bail us out. Isn’t Washington doing the same thing that the private sector did, spending money it doesn't have? Go figure?

Confidence:

Sure Obama will bail us out, create jobs, bail out millions of defaulting homeowners, provide universal public health, embark on the most extensive public works campaign, create deep tax–cuts, and let’s assume he does get some money to Main Street, what will they do with excess funds? They'll use it to bump-up their balance sheets, they’ll start saving — (a process that has already begun with the bank bailouts and is, by the way, bullish for the dollar).

Six Trends Ahead:

1) All eyes will likely remain focused on the real estate, mortgage and stock markets while quietly behind the scenes another bubble will be bursting: The bond market. Debt issues from the Treasury to borrow the money planned for the fiscal stimulus will remove trillions more in wealth from investors who have fled to the so-called safety of government bonds. U.S. Treasury long-term bonds are now the riskiest of all assets on the planet. Expect to see a 30% to 40% plunge in these bond prices in 2009 because at some point investors are going to balk at all of this debt issuance... and when they do they'll demand higher yields to buy US debt, driving bond prices down and interest rates up making long-term treasuries the next bubble to burst.

Mortgage giant Freddie Mac said on January 15th that rates on 30-year fixed-rate mortgages fell below 5% this week — the lowest level since it began surveying lenders in 1971.

2) The Fed will continue to bail out institutions like Fannie Mae, Freddie Mac, AIG, Citigroup, Bank of America, GM, Chrystler and others that are sure to fail in 2009 and will be eventually forced to stop the bailouts (at around 2 trillion, current estimates at $1.186 trillion) because the insurance industry’s capital and surplus cushions are eroding fast. There will be an unstoppable chain of bankruptcies. The Fed will also be forced to keep short-term interest rates near zero to try and pump up the economy, setting the stage for a massive re-inflation of virtually all assets (through a weaker dollar).

3) A rise in social unrest all over the world. This includes terrorism, and inevitable attacks on U.S. targets overseas and possibly at home. Don’t expect the Middle East story to go away.

4) Expect the economy to continue to slide, unemployment to soar (10%), corporate earnings to collapse —yet the stock market will surge, then fall in one powerful paradoxical rally after another. Be mindful that these rallies are short term. Use these surges to get out of all this crazy making until consumer confidence returns.

5) The real estate collapse will continue, not just in home markets, but spreading to commercial markets too. Increase unemployment will lead to increased delinquencies, credit will go down. Home equity loans are a thing of the past, REITs will dry up.

6) Real incomes are going to go down – deflation is the way forward and the cure to inflation.

What to expect outside the US?

Developing countries will have to make major changes to their export-only model. This means developing a viable domestic market. That means transferring economic and political power. Simply put: Developing countries lack domestic demand because the ruling powers refused to invest in their own people. Instead they focused solely on exporting and investing their surpluses abroad, as Paulson said. And that means a lot of social unrest could be in the cards in 2009. While developing economies are suffering, they are also dragging down emerging economies. Emerging stock markets declined more in 2008 than developing and will continue to be harder hit.

Consider:
• Emerging markets of all stripes have been cut-off from their funding sources.

• India, also heavily dependent on foreign demand for its goods, is suffering its worst export slump in recent memory. India is off 55%. Overseas shipments plunged 12.1% in October and another 9.9% in November.

• Russia's pure, energy-dependent economy is imploding and unrest is rising. The Russian government has devalued the ruble 11 times since November, and thrown a quarter of its foreign currency reserves at the raging debt crisis. Standard & Poor's has cut Russia's long-term debt rating for the first time in nine years. Russia's RTSI index has plummeted 75%.

• Ukraine is already teetering! They are hugely exposed to emerging markets in Eastern Europe and elsewhere.

•Portugal became the fourth country (after Spain, Greece and Ireland) in the eurozone in as many days to face a rating warning from Standard & Poor, citing high debt burden as a reason for their credit rating being at risk.

• Unrest in Greece

• Scandal in Italy on privatization of pensions and municipal bonds

• The Organization for Economic Co-operation and Development's index is pointing to a "deep slowdown" in the global economy, with Russia, China and Germany posting the sharpest declines. In Germany, November export figures tumbled more severely ... by 10.6% from the month prior.

• Europe's economy contracted at the fastest rate since the 1930s

• Everywhere from Australia to New Zealand and from Argentina to Mexico and even the once-rich Middle East, the worldwide debt crisis, the bust in commodities and the sharp slowdown in global trade are transforming massive booms into instant recessions. Already, Ecuador has defaulted on its bonds because of falling revenues as oil prices continue to tumble. Venezuela is quietly wooing large oil giants to come back and Brazil's Bovespa index is down about 45%.

• Japan has been slammed by its worst recession since World War II... The Japanese Manufacturing Purchasing Managers' Index has been below 50 for 10 straight months. For December, the index dropped to its lowest level in history to 30.8, down sharply from 36.7 in November.

• South Korea'sNational Statistical Office reported that industrial production dropped by 14.1% year-over-year in November, after falling 2.3% in October. That, too, is the biggest decline ever recorded.

• The Economic Development Board of Singapore said manufacturing output fell 7.5% in November from the previous year and warned that it expects the recession to last...

• Factories across China are closing, unemployment is soaring, and social tensions are rising. China's SSE Composite index has fallen 66%; imports, down 17.9% in November alone; foreign investments to China, off 36.5% from last year. The key thing to keep in mind about China is that manufacturing represents about 40% of the Chinese economy. So this manufacturing slowdown hurts them proportionately more than it does our consumer-based economy. Exports fell for a second consecutive month in December (the first time in the last decade) by 2.8%.