taken from John Pitera's thread.
Late Dec. 2001
By John Mauldin
Mr. Stock Market doesn’t seem quite as sure about a quick recovery this week. But Mr. Bond Market is telling us one of two things: he either believes that a quick recovery or serious inflation is right around the corner (or both). Today we try to figure out if Mr. Bond Market knows something we don’t, or if he is sending his Bond Vigilante troops (those investors who see inflation as the biggest evil) to fight the last war.
I remember as a kid walking through a meadow near my home in Bridgeport, Texas. The tree line was dense on one side. Walk one way and you could travel in the woods for a long time. Take another path and the tree line quickly broke and opened into another meadow.
So, are we on a path through a forest full of bears or just about to break into a peaceful meadow of grazing, fat bulls? Let’s look at the financial data trees in this economic forest for a few clues.
The Incredible Shrinking Forest
First, it appears the trees are shrinking. Deflation is becoming a worry. Even the talking heads on CNBC have used the “d” word a few times in recent weeks. November US wholesale prices went down 0.6%, after a drop of 1.6% in October. This is not a post September problem. Prices are down over 1.1% for the year.
Import prices into the US were down 1.6% for the month, and industrial import prices were down 5%! Import prices are down by about 9% from last year, and even export prices are deflating by 2.5% over the last year. (Greg Weldon)
Companies have defaulted on a record $107 billion of debt in 2001, and default rates have soared to a 10-year high, Standard & Poor’s said in a study released Wednesday. “The absolute number and dollar amount of defaults are unprecedented,” said Brooks Brady, author of the study issued by S&P.
This year’s default total dwarfs by more than 150% last year’s record $42.3 billion, S&P said. 196 issuers have defaulted this year, surpassing last year’s record of 117. S&P said the default rate for high-yield, or “junk” rated issuers is 8.9%, and for “investment-grade” issuers is 0.6%. Those rates peaked in 1991, the last time the U.S. economy was in recession, at 12.7% and 0.8%, respectively.
Junk bond funds have turned back down after flirting with a break-out. Imploding debt is deflationary, by the way.
But it is not just in the US. Canada exports 80% of its products to America. In just the last 5 months, Canadian prices to the US have dropped 8%. Canadian businesses are kissing their profits bye-bye.
The European Central Bank said economic growth in Europe will be as little as 0.7 percent next year, the weakest in at least seven years. The bank forecast that inflation will slow next year to less than 1.1%, even as they stubbornly refuse to cut rates fast enough to boost their economy. Like generals fighting the last war, they fight inflation and make the deflation rolling over the world worse.
I should point out that this is the same Central Bank that blithely told us last year that Europe was immune from any slowdowns that might affect the US and Japan. The only major central bank more clueless than Europe’s is that of Japan.
For the first time since 1992 the UK unemployment rate rose two successive months, rising again in November.
Commodities prices are down, at multi-year lows. Copper, seemingly giving us a signal a few weeks ago that the worst of the economic woes were over (it is often considered a leading indicator) is now re-tracing its gains and threatens to go to new lows.
Japanese Inflation Increases?
Japan continues to implode. Tokyo (and the yen) burns while the
government fiddles around. I don’t have the space to repeat the usual
idiocy from Japanese leaders, but they have been in good form this
week. The only thing inflating in Japan is the level of denial by
their central bankers and government leaders
Core private-sector machinery orders fell a seasonally adjusted 10.1% in October from the month before to a 14-year low. Business confidence is at a the lowest levels in several years, telling us things are likely to get worse.
The yen tumbled to a three- year low against the dollar after a report said Japanese companies are failing at the fastest pace since 1984, fueling concern a recession in the world’s second-largest economy will intensify. 1,851 companies filed for bankruptcy.
And not just small companies. A retailing company called Daiei is going down with $18 BILLION dollars in debt. Japan is on its way to a second record year of bankruptcy debt filing. No wonder Japanese banks are in serious trouble.
Even as Enron drops to under $1, many Japanese stocks are dropping to under 100 yen. Asahi Bank is now at 59 yen. For the record, Asahi is roughly the same size as Bank One. It is going down for the count.
Let me give you an idea of the level of the problem. If you are a small US based hedge fund, you can borrow money for about 2% over LIBOR, or the London Inter-Bank Rate. Bigger funds and banks get better rates. (Today that is about 4.5% or less as one year LIBOR is around 2.5%.)
If you are the Bank of Tokyo Mitsubishi, you have to pay LIBOR plus 1.2% to borrow on the world market! Asahi must pay 2.5% on top of LIBOR. When small players in the private banking world can put together better financing deals than mega-size Japanese banks, there is a real problem.
I could write for pages about world problems. They are legion.
Why should we care about the rest of the world? Around 25% to 30% of S&P 500 company earnings come from overseas, estimates Morgan Stanley global economist Joe Quinlan. For many U.S. companies, the global downturn will pack a sting. Quinlan also worries that as the U.S. recovers, and other parts of the world continue to suffer, the dollar will strengthen, further sapping overseas profits. I think he is right to worry, as we will see below.
So, when Mr. Bond Market tells us inflation is in our immediate future, the data is telling us otherwise.
Mr. Bond Market and his troops, the Bond Vigilantes, are busy fighting the last war. The US money supply is rising at a blistering pace. Greenspan and crew can’t seem to print it fast enough. In the past, that has always meant inflation. If this rate of growth had happened in 1985, gold would have soared to $2,000.
Today, it can’t even get out of bed without stumbling. Gold, commodities and world trade prices are telling us the old equation that increased money supply equals increased inflation is no longer working. Someone has introduced some new variables into the equation.
I think one new variable is supply. Capacity Utilization numbers came out today, and in the US it was down to 74.7% in November, down from 75% the previous month. That’s the lowest since May 1983.
“Investors were encouraged by news that inventories fell 1% in October - the biggest drop in 19 years. Good news. Many said that an economic revival was almost assured, since businesses would have to rebuild their inventories.
“But why would they do that? The bad news is that sales fell faster than inventories in October - down 1.4%. And in November, retail sales dropped 3.7% - the most they have ever dropped since record-keeping began in 1992.” (Bonner)
Capacity utilization around the world is like the Old London Bridge song we sang as kids: falling, falling, falling. That is precisely why import and export prices are falling. Manufacturers are cutting prices to keep factories busy. Every firm is trying to be the last man standing. Companies that cut prices do not usually increase earnings.
The second variable is an esoteric statistic called the velocity of money. You can go to the Federal Reserve of St. Louis web site, rummage around for a while and find out that the velocity of MZM (or cash) is slowing. It is the lowest in 17 years, which is the first year for which I can find numbers.
The velocity of money roughly corresponds to how fast we spend money. Clearly, the stats are saying we are holding on to our money more. The faster money moves, the more inflationary it is. Slower velocity means lower inflation - or deflation.
No wonder we are spending less. Credit card delinquencies are at all-time highs. I wrote about record mortgage defaults last week. Unemployment is at 5.7% and rising weekly. Mortgage rates are back up to 7%, so we can’t re-finance and get more money. My daughter, who is buying a new house next month, has watched her payments rise $200 per month waiting for her house to be built. She is not sure who the Bond Vigilantes are who are wrecking her mortgage rate, but she would like to send them a bill for the damage.
Finally, bank loans are down. Banks simply have more money and fewer borrowers, even at lower rates.
Greenspan can increase the money supply at record rates and still not cause what once would have surely been massive inflation due to low capacity utilization, slow monetary velocity and a poor bank loan environment.
Is there some level of monetary growth that will bring inflation.
Absolutely. But the data tells us we are not yet there.
Conspiracy Theorists, Unite!
My favorite source for “good stuff” is Greg Weldon. His Washington, DC economic inside sources tell him that there is a deal brewing between the US Treasury and the Japanese. I bring you this because it has the ring of reality to it.
As I have reported for months, Japanese officials have repeatedly told us they intend to devalue the Yen against the dollar, making Japanese imports cheaper in the US and world markets. If you are in the business of manufacturing something that competes with Japanese manufacturers, this is not a good thing.
I think the Yen is going to 130 or higher. In effect, this is a 10% cut in prices from Japan. This is clearly going to hurt many US businesses. Normally, Treasury would be all over Japan for doing this. Weldon’s sources tell us that Treasury will sit still for this.
But the quid pro quo will be that Japan buys US bonds. Japanese banks already have billions in US long bonds. They are watching their portfolios shrink, at a time when they can least afford it. If they dump their US bonds, that makes the yen go higher. That is not what the Japanese government or businesses want. It is certainly not what the US wants, as that would artificially send long rates up here, making mortgage rates go even higher, making a slowing housing market even slower and maybe even seriously depressing housing.
What’s a world leader to do? You could agree to a falling yen if the Japanese agree to buy more - lots more - US long bonds. That brings interest rates back down which would be good for the housing industry and business in general. It also makes long bonds rise in value which helps Japanese banks.
It could give a needed boost to the Japanese economy, allowing them to start growing. Seems like it works for everyone.
Everyone, that is, except for those who compete with Japan and by extension Asia. They lose. This whole move, by the way, is a big-time deflationary force, as it holds prices down, if not makes them drop further.
Do you think the rest of Asia will stand idly by and let the Japanese lower their currency and lose market share to the US? Not on your life. They will also work to make their currencies weaker so their industries can compete with Japan.
But this has a very perverse effect on the US. Let’s say Korea notices that 50% of its businesses are at a competitive disadvantage to Japan businesses solely due to currency values. To compete, they lower their currency. (Lower is a nice word for destroy value.)
But the other 50% of exporting businesses which do not compete directly with Japan also get the benefits. Now, businesses whose primary competitors are in Korea have a problem that is directly related to Japan, even though they may not even compete with a Japanese business.
You can look at the currency charts. The Asian tigers “compete” with each other to see who can have the cheapest currency. You can bet if the yen goes to 130 that the other currencies in the region will also drop.
That is not good for profits in the US, and it also means it is not good for US companies that depend upon exports to Asian foreign markets.
The steel industry is example numero uno. Today, the Wall Street Journal reports the Bush administration is in Europe demanding that other countries cut their steel production, as our steel firms are having serious problems against cheaper foreign steel.
The chances of an agreement for production cuts are only so-so. But let’s be optimistic and say everyone agrees to play nice and the US steel industry dodges a bullet.
Then, Wham! Asian steel drops another 10% just from currency devaluation. We are right back in the same place. Run this scenario over hundreds of industries. It is called deflation.
Short term, Mr. Bond Market can wreak havoc. Long-term, his Bond Vigilante troops are going to become the equivalent of the Taliban soldiers - retreating to caves as deflation carpet bombs their positions.
What’s a Central Banker To Do?
There is more than a little irony in the fact that the Bond Vigilantes are choking off the very recovery they see in the economy. This has got to be driving the Fed chairman nuts.
Rate cuts are having little effect. If he doesn’t keep increasing the money supply at a rapid rate, straight-up deflation will become serious. That would be a disaster for the economy. Look at Japan.
If long rates don’t go down, then the economy will not recover very fast and certainly not for a much longer period. But long rates won’t go down as long as bond traders think inflation is coming back, and a rapid growth in the money supply is signaling (falsely, I think) that inflation is coming back.
If you let the Japanese devalue the yen, US businesses get hurt. Yet if the US economy does not recover, the US business and the world is in for a serious recession or worse.
Greenspan has no good choices, and few potential rate cuts left. Yet he is the man everyone is counting on to pull the levers and get the economy growing again.
Where’s the lever for lower long rates, a recovering economy and no inflation/deflation? It may be in Japan, dear reader. But that lever, while it may be the best (in a central banker’s view of the world) of a bad lot, will insure that the recovery in the US will be tepid and long, as it almost guarantees that profits will be harder and harder to find without more cuts in capital spending and employment.
This is what happens when governments meddle in the free markets. Like many a political campaign, you are left with a series of bad choices.
Whichever lever gets pulled, the result will be what I wrote about three weeks ago - the long cycle tells us that we are in for a decade of lower profit growth.
(In the interest of full disclosure, I am currently long bonds big-time in my portfolio, so you can either say I am putting my money where my mouth is or I am letting my investment portfolio influence my views, or both.)
Stock Market Worries
As noted last week, the NASDAQ is close to the same Price/Earnings ratio that it was when the index was at 5000. Profits are eroding faster than price. The earnings picture for technology is bleak for the next few quarters. This makes me very concerned about the markets in the next few months.
The recovery is still at least two quarters away. While the market could ignore the problems in the meantime, I think it likely we get one more real test of the September lows. This would be the strangest bear market in history if we were to see the bottom at the highest valuation levels in history. Markets do strange things, but this seems like a sucker bet and sucker rally to me. It also looks like it could crumble.
Enron Notes
I read with interest the CEO of Enron’s accounting firm, Arthur Andersen’s excuses. They were terrible. There are no good explanations. Either Enron executives committed outright fraud (possible, but hard to see how the entire executive team would conspire to hide things from the auditors and risk jail) or the auditors were either incompetent or complicit. You can’t hide that kind of cash-flow in “off-balance sheet items” without leaving some kind of trail. Profits don’t just materialize out of thin air. Someone badly slipped up.
My bet is that Andersen will use something like “We followed standard industry practices.” They are supposed to be hard-nosed professionals. Investors count on these firms to give reliable and trust-worthy audits. If Andersen knew about off-balance sheet financing, they should have put a note in the audit, whether or not “industry practice” allowed its non-disclosure. The only reason not to is to keep a large fee-paying client happy. They deserve the grief they are going to get. Hopefully it will mean we get more reliable audits this next season. |
