John Maudlin still sees deflation as the dominant economic force this year and looks for the stock market to retest the lows before long.
Deflation, Pure and Simple.
Japan's Currency and Bonds to Collapse?
Et Tu, Switzerland?
Something Vicious This Way Comes
Housing Beginning to Weaken
Come Fly With Me
By John Mauldin
Last week's 2002 Forecast laid out the clear cut case that deflation
would be the dominant economic force in the first part of 2002. I
took pains not to use any recent data, trying to make the case on
long-term economic patterns. I have always felt it is dangerous to
use weekly data to make long-term forecasts.
As the months roll along, we will look at the weekly data that comes
out to either confirm my belief or force me to change. Also, we will
be looking for signs of returning inflation and a weakening dollar,
both of which could have a major impact on the outlook for long term
bonds and the stock market.
(First, I will be in Phoenix, New York, Philadelphia, Boca Raton and
California in the coming weeks. See details at the end of this e-
letter if you would like to meet.)
Today, we are going to look at a slew of reports. Each report will
be like a thread, weaving a tapestry. When we are finished, we will
stand back and see what kind of picture it is showing us.
First, let's look at a few headlines which crossed my computer this
week:
Subject: Yen Plunges as Officials Signal Japan Won't Try To Stem
Decline -
Subject: Japan plays its final card in battle to revive growth -
(London Financial Times): "Until a couple of months ago it was the
strategy that dared not speak its name. Recently, however, Japanese
policy makers have been quite brazen about seeking a weaker yen. With
interest rates at zero and credit rating agencies breathing down its
neck about the government deficit, Japan has exhausted all other
conventional macroeconomic techniques to revive the economy. But
economists say it is doubtful that the last-resort policy of yen
depreciation will succeed where other techniques have failed."
Subject: Yen's fall risks Malaysia devaluation - (BBC): "Malaysia's
Prime Minister Mahathir Mohamad has said his country may be forced to
devalue the ringgit, if the Japanese yen continues to decline in
value."
Subject: Korea Says It May Takes Measures to Counter Yen's Drop -
(Bloomberg): "South Korea signaled it may take measures to weaken its
currency as the yen's decline threatens Korean exports. 'The weaker
yen creates a burden for our exporters,' Finance Minister Jin Nyum
said
I could quote articles from other Asian countries with much
the same tone. I have been documenting for over a year
the "competitive devaluation" that Asian countries are committing. It
is now going to get serious. My friend Greg Weldon uses the analogy
of a NASCAR-type Devaluation Raceway, and notes that the green flag
is out and all cars are at full throttle.
Subject: Japan seen on the road to default - (Japan Times)
"The negative net worth of the Japanese banking system is somewhere
above the yen equivalent of $1 trillion. When the banking system
collapses . . . the Bank of Japan will need to inject at least $1
trillion into the banks to protect depositors from losses," says the
latest issue of the Economic Outlook report by the American
Enterprise Institute for Public Policy Research.
"Such systems will probably result in nationalization of Japan's
banking system, since the government will have underwritten its
solvency," it says. As a result of the issuance of a huge amount of
government securities, Japan's public debt will jump immediately by
about 15%, and the surge in liquidity will cause Japan's currency and
bonds to collapse, the report says.
"Japan's deflation and debt crisis now constitute systemic risk to
the global economy," it says. Japan needs "a massive direct injection
of liquidity into the economy -- not into the moribund banking
system -- through the direct purchase of foreign bonds, corporate
bonds and land by the BOJ," the report says.
I should point out that the American Enterprise Institute is normally
a very sober group of analysts. You don't often read such dire doom
and gloom from them. They are essentially saying that over the next
few years, the Yen is likely to get much worse than the 150 I
predicted last week. Given the stance of their neighbors, that they
will match any devaluation, it does NOT bode well for the US or the
world. The Japanese will not take the recommended step of direct
injection of liquidity, but will do everything they can to save their
banks and save face. Count on it. This will also be the worst thing
they could do as far as the US economy is concerned. (more below)
Prices Continue to Deflate
Let's look at another thread.
Subject: US December Import Prices Fall 0.9% - Fell Record 8.9% in
2001 - (Bloomberg): "Prices of goods imported into the U.S. fell in
December and declined more in 2001 than at any time on record, as the
recession weakened demand."
Subject: 2001 Decline in PPI biggest since 1986 - (Bloomberg): "For
the year, the price index fell 1.8% after rising 3.6% in 2000.
Subject: European PPI will be down at least 1.5% (Wledon):
Last week I noted that the CPI (Consumer Price Index) has been
essentially flat for six months, down from the already low area of 2%
during the first part of the year.
What is happening? Deflation, pure and simple. First clue, let's
look at falling import prices. I cannot find statistical surveys ( I
looked and hope someone has the data somewhere for me to look at),
but I would bet you a dollar against a donut that the bulk of the
import price decline was due to Asian imports. If you look at the
Asian price export data I have quoted over the last six months, you
will note that many Asian countries are getting 20% or less for their
goods in terms of dollars. That is a huge one year swing.
That 8.9% drop in prices does two things. It lowers our consumer
prices directly and indirectly lowers them as US producers are forced
to charge less to compete. That means everyone makes less profits.
Example: the combined market share for General Motors, Ford and
Chrysler has shrunk to 63% from 71% over the last four years. That
means lower profits, lost jobs and slower growth as these firms
purchase less from US manufacturers. Just today Ford announced they
would close 5 plants and lay-off 35,000 people, on top of the
declines they have already announced. They do this in an effort to
stay profitable, but it comes at enormous job cost to US workers.
One of my favorite analysts, Bill Gross of PIMCO, in an article
fretting about the direction of the dollar wrote these words. I
couldn't say it better, so we read his:
"Now, in the midst of a global recession, our 'strong dollar' policy
may be just what the doctor ordered for our competitors to revive
faster than the good ol' U.S. of A. Not only has Japan gotten the
message that a weaker currency is better but, Asia as a block may
soon pile on the devaluation band wagon as a way to survive and
ultimately thrive in this era of slim pickens. 'Competitive devals'
were tried in the 1930s and went under the name of 'beggar thy
neighbor' policies.
"That they cannot work collectively is indisputable, except for the
monetary stimulation that usually accompanies them. Selectively,
however, it is possible to beggar your neighbor and we are being
beggared right and left these days. When the Swiss Central Bank
proclaims that it no longer wants the Swiss Franc to be viewed as a
safe haven currency, you know the world is turning topsy-turvy."
I highlighted the phrase: "they cannot work collectively" because
that is the crux of the issue. Everyone in Asia is trying to make
them work collectively against the US, as the initial headlines in
this e-letter demonstrate.
Et Tu, Switzerland?
It seems that European Central Bankers would like a somewhat stronger
Euro, which would be fine by me. We need some countries to show some
sanity and stop this competitive devaluation. Competitive
devaluation on the scale it is being practiced today will lead to
further deflationary presures.
But now, as I read the above from Gross about the Swiss wanting to
see their currency weaken, it reminded me of a quote I read in a
recent Greg Weldon letter. (He writes 3-4 a day, so it is sometimes
hard to remember exactly which one.) But I looked and found it:
"Competitive Currency Depreciation: From Asia, to Europe, to South
America, green flag waving can be seen. Today's "track" is in
Switzerland, where the Swiss National Bank has made it's displeasure
with the CHF strength against the EUR well known. One of the most
outspoken members is Bruno Gehrig. Note his latest comments:
"I would argue that given the current cyclical environment, a
somewhat stronger Euro (against the CHF) would be a helpful element,
in our own economic environment. You could always fix the exchange
rate somewhere. You can always create enough means to achieve a
desired level.."
"WOW," continues Greg, "yet another sign that some central bank
thinking has mutated, and is swinging towards belief that at least
SOME "inflation" is needed."
Let me read that again. It seems to indicate the SWISS might be
thinking about devaluing their currency! I remember in the 80's when
low paying Swiss Annuities were sold as the paragon of stability.
Investors suffered the low yields in order to get a piece of the
economic rock that everyone considered the Swiss to be.
Let's carry the race track analogy further. "Where," we might
ask, "is the Red, White and Blue #1 car?" Scanning the track, we find
it in the pit area, being re-fueled. If you have ever watched a race
car come into the pit, you see the pit crew frantically changing
tires and re-fueling. They use a high pressure pump and a big nozzle
to literally force the fuel into the tank.
Looking closer, we see the leader of the pit crew. He looks familiar,
with odd glasses. In fact, pit boss Alan Greenspan is directing the
crew to use new high octane fuel. But the engine is using the fuel
almost as fast as they put it in.
Why can we increase the money supply at such huge rates as we have
done this past year, and especially the last few months? Why can't
our economic tires find traction?
It is because of the "beggar thy neighbor" policies (mentioned
above) of other countries. They are exporting their deflation to us,
and at a dramatic rate.
Greenspan is trying to "re-inflate" the economy, just like the Swiss
want to, but he has a problem. Normally, his efforts would mean a
lower dollar. That is part of the ebb and flow of currency
valuations. But today, the dollar is the reserve currency of the
world. As fast as he prints it, other nations are buying it. Either
that, or it goes into the current "Son of Bubble" stock market .
If he prints it too fast, bringing back inflation, the world would
lose faith and the dollar could drop like a rock. It could lead us
into a serious world recession. Print it too slow and we have
deflation, a slow economy and a very weak recovery. The trick is too
find the level that is "just right".
The problem is that the "just right" level of today's massive money
supply growth will create more problem's tomorrow. But is seems the
central banker's credo is "sufficient unto the day is the evil
thereof" so we will worry about tomorrow's evil tomorrow. Toay's evil
is deflation.
The implications for our portfolios are obvious. That is why we will
be watching the dollar and inflation very closely this year. But
right now, the picture is clear. The threads are weaving a picture
in deflationary green.
Something Vicious This Way Comes
I am writing a book on hedge funds, and am currently working on the
chapter which will make the case that Absolute Return investments as
represented by some hedge fund styles should do much better over the
next decade than the average mutual fund. In doing the research, I
had the chance to go back to my August 29 issue of last year. I re-
read Jeremy Grantham's market predictions in Barron's which I quoted
at length. Grantham manages $22 billion and is one of the sharpest
analysts on this planet. His predictions were right on target. The
interesting thing is that he called the recent rise in the market but
then he says:
"...even if the first good quarter is the first quarter of 2002, it
should be anticipated any day. The bad news is that there is almost
no way this could flow through to earnings. Earnings themselves are a
lagging indicator. The capital spending cycle is very important to
profits, and it is in full-scale retreat. However low interest rates
go, who is going to build a plant that they don't need? No one. So
capital spending continues down and corporate earnings are still
under pressure.
"If the market were to rally to the top end of my range -- up 20% on
a knee-jerk, oh-it-is-all-over, whoopee! -- reaction, the best that
would happen to earnings is they'd be flat to slightly off. [He hit
the S&P at 20% on the nose! - JM] The market would approach its old
high with a substantially higher P/E, because earnings would still be
down more than 20%. So instead of 33 times earnings, you'd see the
S&P priced in the high 30s or 40 times earnings. The economic
recovery will be quite short, two or three quarters, and weak. And
then people will get a whiff of the fact that GNP is going to settle
back down into a 1.5% range again, because of the capital-spending
bust. Finally the negative savings rate will begin to move up, and
that will impact top-line growth. The market is no longer in its old
game. But this will not destroy the economy. I am not a big bear on
the economy at all."
"Q: You could have fooled us.
A: Earnings will be weak and sometime in the middle of next year, or
even earlier, we'll get a whiff that things aren't as strong as we
thought. With the market at 40 times earnings, the next leg [down]
will be more vicious."
He said then what more and more analysts are saying today. J. P.
Morgan analyst Tom Van Leuven now thinks earnings in 2002 will not
grow at all. He sees the S&P at 950 based upon his forecasts.
"In a note to clients that rattled financial markets, Morgan Stanley
chief economist Stephen Roach raised the prospect of a second leg to
the current downturn that could send the economy back into reverse
after just single quarter of growth. That is sharply at odds with the
consensus forecast for a rebound that would begin by sometime in the
second quarter and possibly sooner.
Roach warned Monday that five of the past six recessions have
included "false starts" of economic growth that were followed by
another quarter or more of contraction, and he said that it was
likely the current downturn could follow the same pattern.
"Yes, the U.S. economy now seems poised for positive growth in (the
first quarter) - an outcome that on the surface would seem to signal
the end of recession," Roach said in his note. "But following on the
tendency of five of the past six recessions, I suspect this pattern
could well be reversed with a double dip commencing by springtime."
In an interview, Roach said there was a two-out-of-three chance that
a positive GDP figure in the current quarter could be followed by two
more quarters of negative GDP, meaning the recovery would not begin
until the fourth quarter. (MSNBC)
Then why are so many analysts so optimistic? As I read them, they
are primarily making assumptions about a recovery based upon how
previous recoveries in the economy developed. They assume consumer
spending will pick up soon, and that roaring profits are around the
corner. The "consensus" opinion on tech stock profit growth in 2002
is 46%! The primary reason they assume things will pick up is
because "they always have".
But previous recessions were mostly caused by inventory build-ups and
inflation. That is not the case this time. This recession is caused
by over-capacity and deflation. These are much harder problems
to "fix".
Housing Beginning to Weaken
The Meyers Group is a well known consulting firm for the housing
industry. They issue a closely watched weekly housing report. As
long as I have been reading them, they try to be upbeat, at least
trying to find something good even about bad news. This week they had
difficulty being optimists, as they write:
"The job market continues to erode, and though rates of job losses
and unemployment varied across regions, all the regions showed rising
unemployment in December. These job losses led to further declines
into negative territory in the national Demand/Supply [of houses for
sale] and Employment/Permit ratios, indicating that the current level
of housing production far exceeds the amount justified by employment
growth. To date, low mortgage rates and less restrictive financing
options have allowed the homebuilding industry to thrive in light of
poor economic conditions. However, housing market activity often lags
downturns in economic conditions, leading us to believe we are now
entering a transitory period in which housing indicators will begin
to reflect new economic realities at the local level. (emphasis mine)
This was reflected in Greenspan's speech today. His speech was
bearish, and a large part of the reason was his worry about housing
and mortgage rates.
All in all, between deflation, lackluster capital spending, slow or
no growth in consumer spending, a weaker housing market it is much
more likely we see a continued weakness in corporate profits.
If Jeremy Grantham continues to be right, investors should become
aware of this soon, and become dis-enchanted with the stock market.
He says the next leg down in the stock market will be "vicious". Most
readers think they have already experienced vicious, and would like a
little more kindly market.
But past bear markets are replete with examples of significant bear
market rallies followed by even more significant drops. I continue
to expect a test of the September lows.
It would not surprise me to see this next low coincide with the real
bottom in the economy. I still think we will see a second half
recovery to "growth", but that it will be very weak at the beginning.
I am still long bonds and suggest staying out of the stock market,
except for value stocks of solid companies with favorable P/E ratios. |
