Sunday, 4 July 2010


C o m i n g   S o o n

A year after stock markets bottomed in March 2009, a combination of panic government measures and skillful manoeuvring by central banks appeared to have steered the world's economy into the smooth still waters at the eye of the storm.  

To those navigating the ship and most of its passengers, the threat seemed to have abated.  The skies had cleared, the winds died away and the mountainous waves of 2008 had subsided to the merest of ripples.  No wonder, then, that the captain's been calling full steam ahead.

There's just one problem.  Nobody showed him the satellite picture...

I suppose one advantage of my own investing approach
 is that I've been able to combine a short-term technical view of markets with a moon's eye view on the future direction of the world economy.  This has allowed me to not only take advantage as an investor but to spot major trouble brewing before it's too late. 

So while expressing certainty over short-term market movements is foolish, over a longer-term time horizon I'm rather more confident in my forecasts. I'm not an 'on the one hand, but then again on the other' type of prognosticator, oh no.  Click through the archive and you'll see I've set out my forecasting stall for no less than a decade ahead, based on a particular economic perspective with a remarkable track record (see here) and historical evidence on the aftermath of credit bubbles, credit busts and their associated downturns and depressions.    

(That's not to say my view can't be wrong - I invest with a clear view in mind but prefer to build escape routes into my trades in case I am wrong.  Call me a wimp, but given a choice between being proved wrong and keeping my shirt, I'll take the shirt.)

Anyhow, what an ultra long-term overview can certainly do is help clarify your understanding of how important - or insignificant - any one economic event is in the overall scheme of things.  

Don't you just hate them already?

So when Chancellor of the Exchequer George Osborne - or as I prefer to call him, Nosferatu - stood up at the House of Commons dispatch box on June 22nd and announced the most draconian package of tax rises and spending cuts in British fiscal history (well, I suppose we could go back pre-War but it would spoil my hyperbole) I almost choked on my jellied eels.

By axeing public spending budgets anything from 20% - 30% and siphoning tens of £billions in tax out of the pockets of consumers into treasury coffers, Osborne is virtually guaranteed to suck the life-blood out of our feeble economic recovery and plunge the UK into a double-dip recession.  

Indeed what makes a renewed slump the closest thing to a certainty since England v Germany, is that we are not alone.



Wile E. Coyote in 'Scrambled Aches': sorry folks, Warner Bros. just pulled this classic Looney Tune from Youtube - somebody sue those lawyers!

When we met in June, our indomitable hero - 
Wile E. Conomy - was last seen jutting out high above a ravine, clinging to a rock.

With a careful system of ropes, pullies and catapults, Wile had attempted to drop a huge anvil on the head of his old enemy as he sped beneath.  Unfortunately, the anvil catapulted backwards and smashed through the wafer-thin sliver of rock separating our hero from force of gravity.  

There is now nothing - air, space, void - between Wile and the puff of smoke that awaits him several hundred feet below.

He'll never learn.

Well how's this for an anvil: despite unassailable historical evidence from previous credit busts showing how a withdrawal of economic stimulus invariably derails recovery and leads to another recessionary plunge,  Europe's leaders are without exception preparing...

...a withdrawal of economic stimulus.  

And they're not just easing up on the throttle.  They're slamming on the brakes.  No more than eighteen months after the worst downturn since the 1930s, they have decided unanimously that they've no alternative but to 'do austerity'.  

One after the other, governments have rushed to rip the shirts off their backs and self-flagellate, drawing (their voters') blood as they cut spending programmes to the bone and ratchet up taxes and pension ages.

Why this collective bout of apparent insanity?  Is it some show of mass penitence for the misery-measures they inflicted on Greece?  Why, no.  It's a demonstration of governments' abject terror in the face of their true nemesis - the bond market.


For months now, I've been squawking in this space about governments' vulnerability to the whims of the cat-stroking bond villains.  As poor Greece has shown, once the monster bond markets - $83trillion, bigger than the combined value of all the world's economies - begin to believe that a country cannot sustain its debt repayments, they not only start selling what bonds they may already hold, but start factoring in the potential for default to any further purchases they make.  

And if a country is unlucky enough to have its debt rating downgraded below a certain level by one of the big ratings agencies, there are many financial institutions which are then forbidden to hold that debt.  So it's sold off, which raises rates even further (when bonds are sold, prices fall and rates automatically rise).

So Greece, but also Portugal, Spain, Ireland, Hungary, Latvia and others, have seen the interest rates on any new bonds they issue (and the costs of insuring against the default of those bonds) head higher - in some cases, parabolically higher.  

Spanish 5-year bond yields June 2010

That's right, Jose, you're going down.
This is inclined to set off any number of crises, not least of which is a spike in domestic interest rates.  That's not an outcome any weakened, debt-laden economy can easily withstand.  Look at Spanish bond yields, above. Their government is trying to cope with 20% unemployment - up to 40% among the young.  It cannot sustain having to service its debts at these levels, yet it must keep issuing bonds to pay for its spending and to re-finance its previous borrowings.  If markets finally lose confidence in Spain's ability to repay, it's lights out, Fernando.  So Zapatero must slash and burn, like Greece. 

Greece itself is in a death spiral: it cannot grow its way out of its debt crisis, yet is still being forced to suffer a hideous austerity plan by the IMF.  They are doomed and surely know it,  so it's far from certain that the Greek people will wear the hair-shirts they've been compulsorily issued.  They have a vote - so what's the odds on them voting out their hated government at the earliest opportunity?  

Whether for economic or political reasons then, it is probable that Athens' government will before long either fail to, or refuse to, stump up its debt repayments. Fireworks are coming.

Carl Weinberg of widely-respected analysts High Frequency Economics is planning for an August meltdown

While the dreaded 'contagion' may not yet have got full hold of the bond markets, it's surely raging in the European corridors of power. Watching Greece enter its death spiral and seeing their own interest rates creep higher has clearly put the fear of God into many of Europe's political leaders, who have rushed to be the next 'not-Greece'.

Italy recently announced a $29bn package of cuts, along with the Danes; France has unveiled its own $55bn party-pooper, Portugal has raised taxes across the board while Spain wielded its own axe by slashing public sector pay 5% in a $70bn package of savings.  Even ultra-tight Germany is showing the way with a big slew of cuts.

Not to be outdone, Nosferatu wrapped his talons around the UK economy's neck last month and sank his fangs in good and proper. To avoid the unwelcome attentions of the bond villains he is intent on draining the economy of its crippling public debt.  So he announced the withdrawal and butchery of a swathe of state benefits, an increase in personal taxes, the raising of VAT to 20% and a wild chopping back of public spending programmes.  

His publicly-expressed hope is that the economy will grow despite or even because of this, but privately he cannot possibly believe that.  He insists that by encouraging business investment and entrepeneurship and by slashing back the state and public debt, resources will be freed up for the private sector to expand and fill the void.  Over the very long term I agree this is both necessary and likely.  Until then, expect


  Remember this?  
Back to the future, folks.

How will cuts in UK departmental budgets of 25% or more be achieved in practice?  Nobody has the faintest idea - 
it's never been attempted. Not even Maggie Thatcher in her pomp tried anything as brutal, yet she succeeded in throwing three million people out of work in the 1980s.

If these cuts are actually realized - and the bond villains are watching to ensure they are - it's possible that the destruction wreaked on the economy over the next few years and the social unrest it will unleash will be absolutely unprecedented.  

The Guardian newspaper recently obtained a leak from the government's new independent OBR forecasting unit, which expects these cuts could lead to 1.3 million people losing their jobs.  And that figure does not factor in the effects of a potential 'double-dip' recession.  With the current UK unemployment total standing at 2.5 million, we could easily be looking at a 4 million jobless count inside the next few years.  

This kind of thing couldn't happen here...could it?  

Forget the social impact for a moment.  The effect this would have on consumption in what would be a stagnant economy - especially when combined with a rise in VAT and personal taxes and the withdrawal of benefits - is shocking; retailers would be seriously hit, with high unemployment exacerbating their current woes - high debt levels, consumer credit contraction by banks and a natural long-term slowdown in spending due to demographic factors (see also 'Demographics, the eighty-year flood' from an earlier post).  Consumption is critical - it remains two-thirds of our GDP.

House prices will undoubtedly fall, as people fail to pay their mortgages, demand from public-sector workers slumps and the downward pressure on wages and deepening credit drought means many will be simply unable or unwilling to buy at current values.  

Yet that is a mere parochial worry.  The true reason to be afraid - very afraid - is that we haven't factored in the effect of the entire Eurozone cutting public spending and raising taxes simultaneously - during a slump.


If European leaders want to know what they may have just done, they need to talk to widely respected Japanese economist Richard Koo.  Japan has been in its own interminable downturn since 1990, which is only prevented from slipping into all-out depression by continual government stimulus programmes.  Here's why he thinks cutting now is a recipe for disaster:

So with Europe set to disappear down a deflationary hole, there are now only two legs of the world economy's three-legged stool holding us up.  Continued expansion in Asia and the USA are all that stands between the world and another recession, so surely they must be faring better? 

OK, let's take a look.


It's become a cliche in recent years to talk about the transfer of economic power from the debt-bloated economies of the west to the sleek and fast-growing tigers of the east.  Just as remarkable, however, has been the amazing shift of power in the minds of investors.

Such has been the historical dependence of countries on America to lead world growth, one look at a chart reveals virtually every major world stock market to be a twin of the US S&P500 index.  Yet in the space of three years, Shanghai's stock index has gone from being a deformed shadow of the S&P to a reliable leading indicator which US and western markets now follow.

China (in black) now leads our markets by several months

This is a boon to traders awake to the new order, since it tips them off to upcoming market turns far in advance.  But the above chart also tells a sobering tale about the latest twist in the Chinese economic success story.  Countries across the developing world are now reliant on that success for their own growth - Asian and Latin American nations in particular - but because China's expansion sucks in imports and capital from every corner of the globe, this index is becoming a leading indicator of our own economic future.  And it's indicating something loud and clear.

China is slowing.  In the latest manufacturing and purchasing managers reports, it's clear Chinese industry has taken a marked step back from the breakneck speed it had been growing at since the government's gigantic stimulus programme began in 2008.

With a burgeoning inflation problem and a runaway property boom of gargantuan proportions, China's men in grey have been gently tugging on the reigns in an attempt to avoid creating a US-style bust.  

Amazing structures at the 2010 Shanghai Expo: 
built on borrowed cash, borrowed time

But because their all-important GDP growth depends to such a huge extent on investment in hard assets - industrial plant, factories, office blocks, transport infrastructure, residential housing, not to mention grand projects like Shanghai Expo, above - they need to fuel their state-run banks with credit and make them lend, and local governments are compelled to borrow the available money and spend it to meet targets.  The resultant monster credit boom is alarming even China's top brass. Lending is still growing at exponential rates of 18% per year, but wages are stagnant as is consumption, which remains a puny 35% of their economy.  This endless funnelling of government credit into fixed assets is what famed hedge fund manager and China skeptic James Chanos has called their 'treadmill to hell'.  

Authorities are thus faced with the conundrum of how to keep growth forging ahead (otherwise civil unrest becomes a grave danger) without overheating the economy.  They're still working on that one.

Meanwhile local governments, some of which are the size of Greece, have racked up debt problems the size of...well, Greece.  Eventually this may lead to an almighty financial crisis but, given the political need for China's leaders to keep pump priming their own economy, perhaps it will require a double-dip recession in the rest of the world to provide a trigger.  

Oh look, here's one coming.


Last month I posted a chart of the most accurate leading indicator of American economic growth, the ECRI's Weekly Leading Index.  Since 1968, it has had a stellar record of predicting US recessions and expansions six-to-nine months in advance.  Unlike any other indicator, it has never failed to predict an oncoming recession, and only once has it forecast a recession without one actually occuring.  So, ladies and gentlemen, it behoves us to listen when it speaks. Here is the very latest chart:

Source: ECRI WLI Growth rate, HS Dent

At the beginning of July the index reached -7.7%.  Since 1968, the index has never fallen this low without the economy being either in, or about to fall into, a recession.

There are more signs, many more, that the world's largest economy is in trouble. 

For example, Americans are starting to realize they have a true national debt crisis - though so far it's being played out at a local rather than a federal level.  As the tax take has plummeted, state and local governments, faced with sharp rises in the cost of borrowing, have got to work cutting services.  In the latest gore-fest, the California city of Maywood has laid off its entire public workforce and contracted out its own police department.  Draconian public layoffs are now becoming an established part of the daily news diet.

But the greatest millstone around the economy's neck remains housing.  Housing is what got us into this mess and, if the latest figures are anything to go by, it won't be getting us out.

A 30% (yes that's three - oh) fall in demand in one month, 
the biggest drop on record.


Here's undeniable evidence (as if we didn't know already) that government tax credits to home-buyers merely pull forward future demand into the present; once those tax bribes are removed, the subsequent plunge is even more dramatic than it otherwise would have been.

In addition a glut of foreclosures - four million or more by some estimates - is set to work their way through the banks and eventually out into the marketplace.  Never mind the effect of all this on bank balance sheets and on Wall St - it will depress prices on Main St for years to come.

The bottom line?  Take a look at a long-term overview of US home prices versus incomes, courtesy of Barry Ritholtz's excellent The Big Picture blog.

Source: Barry Ritholtz, Ned Davis Research

The mean ratio of prices to incomes over the past 30 years is 4.1 times - and this includes the biggest housing bubble in US history which, some might say, lifts the ratio to an artificially high level.  Yet even if one leaves the bar at 4.1x, house prices are still too high relative to incomes despite a 33% decline to date.  And since corrections almost always drop below trend before finally stabilizing, prices seem sure to fall further.  

How low could they go?  The experience of Japan shows that, if deflation, mortgage famine and sinking demand take root in the economy and continue for long enough, a 50% - 90% fall in prices is possible.

A crash followed by 16 years of small declines 
meant an average 70% haircut for Japanese homeowners.

Tying in to the property picture is the latest data on jobs. The recent unemployment picture has frustrated the many bullish forecasters who have, carefully laid out before them, the template of previous post-recession recoveries.  But as I've always said folks, this is not your cookie-cutter recovery.  

This is the big one, friends.  This will take years.

Unemployment claims are now ticking back up while private sector job growth is way, way below what it should be if this were a normal cyclical recovery.

Part of the reason why US companies aren't hiring is that American banks still aren't lending.  This is the trend folks - there's no other way to describe it but frightening.

US and European banking regulators are laying down new rules to make banks keep a greater cushion of capital - which is of course a further inducement for them to hoard.  And when banks don't lend, money supply falls, creating a potential deflationary vortex.  In fact, the fall in US money supply to date is the steepest since the Great Depression.  Until this reverses, a lasting recovery is absolutely impossible.



Wolfgang Petersen's Hollywood blockbuster was based on a true story about a crew whose boat was caught in the 1991 'Halloween Nor'easter'.  This was a storm which came from the confluence of three vast atmospheric phenomena; each on their own would have created havoc, but their convergence on the same day and in the same location created a truly deadly depression.

It seems to me not inconceivable that the effect of a simultaneous drop of the United States into recessionary territory, along with China's attempts to slow growth to restrain its debt and property bubbles, together with Europe's descent into an orgy of debt-busting austerity, could yet tip the world economy into all-out depression.  

Perhaps we will miraculously escape these forces.  But if we don't, there is no magical source of stimulus this time to cushion our fall.  Political will is non-existant or downright hostile in the west, and in the east they know that any further stimulus there will lead to an almighty inflationary bubble.

Is it possible that, this time, the game is finally up?  


Well, that's quite enough depressionomics for one month.  

Now, housekeeping.  For various reasons, I've decided a change in the format of your Investment Outlook is in order.

As things are turning south, fast-moving developments in markets are set to make a once-a-month Outlook pretty much redundant (I've already had to post an uncommon slew of updates).  So I've decided to start posting my little investment nuggets in the more traditional manner - ie. whenever they pop into my head.  

I will still cover all the bases - stocks, bonds, property, commodities, savings etc. etc., but they'll come in timely bite-size chunks rather than in one humungous slab.  The first of these nuggets is below, or here.

The meat of the blog, my monthly opinion piece, will remain as is, coming to you next on Sunday August 1st.  Meanwhile I trust you've been enjoying our brilliant, scorching, sun-soaked British summer.  And if you're not in Britain, for God's sake get over here now because it'll probably never happen again.

Have a great month!