I've posted John Mauldin's stuff before. I think he's great. Here are his views on 2002.
By John Mauldin
My annual predictions letters for the last two years have been easy to
write, and with one glaring exception, have been generally on target. I
start with a basic premise - one key economic factor -- and work out from
there. I look for the one thing I believe is going to affect the economy
more than anything else in the coming year. If I am wrong on my basic
premise, then everything else is likely to be wrong.
In 2000, it was the bursting of the bubble and in 2001, it was the coming
recession. Both seemed obvious as I wrote about them then and hindsight has
been kind to those prognostications as well.
Today it is not so obvious or easy, at least for me. I have spent a long
time reading and thinking through the hundreds of pages of data and
forecasts that are sent my way, many of them quite expensive indeed. To say
there is more contradiction and disagreement than normal is an
understatement. Well-respected experts look at the same data and come to
quite different conclusions. Some see only "onward and upward" and others
see the "end of the world as we know it."
Each group cites a mountain of economic data to support its position. The
problem at hand is that we have never seen this combination of data before.
Using history as a basis for prediction, as long time readers know I like
to do, is fraught with problems. We are in uncharted waters. There is no
historic parallel, so we are left to our own predictive devices.
On the Gripping Hand
It reminds me of the subject of one of my favorite science fiction books.
The authors postulated a three-armed alien. Their third hand was called the
"Gripping Hand". When in an argument with this clever species, they would
come forth with three opinions. You would have to listen to: "On the one
hand, on the other hand, and then on the Gripping Hand." I always thought
they would have been ideal economists.
I think both those in the total doom and gloom fatigues and those in the
cheerleader uniforms are wrong. We are going to try to "get a Gripping
Hand" on the 2002 economy by looking at the data.
This letter is about twice as long as normal, but it is full of hopefully
thoughtful research and predictions that you will find useful. You might
want to read this when you have 15 minutes or so. Sorry it took a few extra
days to get out, but there was just a mountain of data to weed through and
assess.
For now, I'll give you the executive summary: I have come to the conclusion
that the over-riding economic factor for the first half of 2002 will be
deflation. "Imported" deflation is going to affect every area of our
economy and investments. We will see a second half recovery in the economy,
although it will be different in size and scope from previous recoveries,
which are usually "V" shaped and quite robust.
Investing will be even trickier in 2002, as the Fed and world response to
deflation, and the resulting problems that are created by their response,
is anybody's guess. But the conventional wisdom of market cheerleaders
(which passes for market knowledge) will be as wrong in 2002 as it was in
2000 and 2001.
This year we will have to keep our eye on several stats new to this letter.
Could we see a return to inflation in the second half as the Fed continues
to pump? Has Greenspan tightened for the last time in his career, as some
very savvy analysts assert? We will explore all this and more as we look at
2002. Let's go to the numbers as I lead you through the economic minefield.
Deflation Comes to Our Shores
Deflation is not a new theme for this letter. I have been predicting it
since late 1998. It now seems to be here. Has anyone noticed that for the
last six months of data available (June through December) that the CPI
(Consumer Price Index) actually dropped? Not by a lot, but at an annual
rate of approximately -.3%, (give or take a tenth) which is unprecedented.
The bond market certainly does not believe such numbers will last, as
interest rates continue to climb as I write this.
However, the very reliable Bank Credit Analyst notes that their inflation
predictor is at a very low point, showing almost no inflation in our
future.
The Producer Price Index (PPI) is down 1.1% for the year and for the last
six months is down 2.5% or an annualized rate of approximately 5%! The
numbers are certainly at the lower end of the range and suggest that a
further easing of prices in the CPI is in the future.
For the record, I understand the difference between monetary inflation and
price inflation/deflation. We will explore later why we are seeing price
deflation while the Fed is increasing the money supply at record levels
(monetary inflation). As deflation is my basic theme for this year, we will
go into it in a little more detail.
Importing Deflation
I am often asked how can a country export its inflation to another country?
It is not a hard good or service which one country would willingly buy from
another. Yet economists speak of "exporting deflation".
To begin with, let's look at Exhibit "A": Japan - the world's second
largest economy. I have written at length about Japan in recent issues, so
I will just summarize here.
The GDP (Gross Domestic Product) in Japan fell 5% last year and is now at
the lowest level in 6 years. The GDP deflator (an obscure but important
statistic) is now back at 1990 levels. Such trends have not been seen since
the 1930's. (Bank Credit Analyst)
Japanese national debt is at 130% of GDP. If you add in the bad debt that
the government will have to assume from the cascade of bank failures that
will happen in the next few years, the debt load will increase to 160%
(Morgan Stanley). That is huge. And that is debt that is on the books. Off-
budget debt such as government guaranteed pensions in an aging country is
not included and is staggering.
Japan is rapidly approaching the end of its rope. It is reasonable to worry
about the economy imploding, as it will have severe effects on the world
economy.
Japan has used "fiscal stimulus" for ten years to try and get their economy
jump-started. They finance huge public building projects to keep the
building contractors working. They spend and spend and spend. They have
borrowed to the teeth to do so, and for little results.
Tax receipts are going down, and spending requirements are going up. But to
raise taxes would drive the economy down further. To increase deficit
spending would threaten Japanese bond ratings. S&P has already lowered
Japanese government ratings, which must be humiliating for the face-saving
leaders of the second largest economy in the world.
As mentioned above, bad debts at all levels of banks are huge. Many of the
country's largest banks are more than technically insolvent. The main
reason that the Japanese economy has not rebounded since 1990 is the
failure to simply close out bad bank loans.
Capital is being loaned to companies which are basically brain dead and
have no chance of growth. Japanese banks continue to loan money in order to
keep from recognizing that the companies they do business with are
insolvent. This keeps smaller companies from being able to get access to
loans, and finance companies that should be allowed to collapse. They
continue to compete at a loss instead of getting out of the way of better
managed firms.
Further, Japan depends upon exports for its very survival. But it now
competes with the rest of Asia in a number of its key industries,
especially for the attention and money of the US consumer.
Let's see if we can summarize: government debt and deficits that are too
high; they can't raise taxes; exports are down to dangerously low levels;
growth is negative and getting worse; deflation is ravaging the country;
unemployment is at an all-time high; banks are collapsing left and right;
the reforms which are needed are being fought tooth and nail. So, what's a
government to do?
In a time honored tradition, Japan will monetize its debt and destroy its
currency. Yes, you heard it here. Japan has decided that its only real
option is to become a banana republic.
I have been telling you for months that the official policy of Japan is to
now devalue its currency. The yen has dropped to 130. 130 is now the floor.
Morgan Stanley analysts think it could go to 150. I agree, although we both
may be optimists considering the nature of what Japanese leaders are
contemplating.
Wasn't it just a few years ago that the yen was at 80? This means that if
you are a Japanese consumer, it already takes 60% more yen to buy a dollar
than just a few years ago, and your government is hell-bent on adding
another 40% cost increase. But if you are buying Japanese goods with
dollars, there are some bargains to be had.
What does this do for Japanese business? It means their products are
cheaper outside of Japan. If the US steel industry thinks it has problems
competing now, just wait till later this year. Japanese manufactured
automobiles (like my daughter's new Lexus SUV) will be even better values
within another few months. If you are GM or Ford, your worst nightmare is a
loaded $30,000 Lexus luxury SUV selling against your $40,000+ models.
The plan seems to be to make Japanese products so cheap that everyone will
want them and thus the Japanese economy takes off. Of course, that also
means Japanese businesses will have less competition from abroad, and can
improve their profits and their balance sheets at the expense of the
Japanese consumer. The consumer, fearing prices might rise, might actually
come out of their cocoon and buy something.
If this was just a problem for Japan, I might feel sorry for the Japanese
consumer, but would not really care all that much. But it is far more.
By Japan making their products cheaper, that lowers prices of their
products in the US. It makes US companies keep their prices and profits
low. In fact, it means they will actually have to lower prices. This is
deflationary.
But it gets worse. Much of the rest of Asia will not sit idly by and watch
their competitive relationship vis-…-vis Japan deteriorate. They will also
continue to devalue their currency in what will be a competitive
devaluation policy. I have been writing about this for well over a year,
and my prediction is that I will be writing about it for this next year as
well.
When Korea, Thailand, Malaysia, Singapore, Taiwan and others drop their
currency values in line with the yen, that not only keeps them competitive
with the products for which they directly compete with Japan, but also the
entire spectrum of their products.
US companies are going to face pricing pressure like they never have. More
and more manufacturing jobs will leave the US, as companies are forced to
either shut their doors or manufacture offshore.
But what if you are a company doing business in Asia? Your products now
cost more to those consumers, so you sell less of them. Further, your
profits as denominated in dollars are less, so your US balance sheet is
weaker. UGLY, UGLY, UGLY.
In essence, Japan is exporting its deflation to us, and forcing its
neighbors to follow suit. While this may be a relatively small portion of
our economy (in the grand scheme of things) it will be significant enough
that overall prices will drop.
More Deflationary Pressures
Monetary theory says that inflation is an increase in the money supply, and
the Fed has certainly been doing that, although it is not evident in prices
(yet). But we are also watching paper burn.
Let's take Enron. The loss of Enron stock is only a true loss for the
economy to the extent of invested capital. If someone bought Enron for $50,
someone also sold it for $50 and there was not a net difference to the
over-all economy, although individuals feel the pain or gain.
But Enron is more than its stock. Bond holders are going to watch physical
dollars disappear. Gone. Bye-Bye. As the dust settles, this could be
upwards of $4-5 billion. JP Morgan may be out $2+ billion alone, depending
upon whether their bond insurers have to pay up.
This paper burning is deflationary. Right now, companies are defaulting at
record levels. So are consumers. Every dollar that disappears is
deflationary. This allows the Fed to increase the money supply at higher
than normal rates without bringing back inflation.
And it is not just companies. Argentina debt is going up in smoke as I
write. I warned readers about Argentina almost two years ago when it seemed
you could get a "safe" 16% return. Now investors will be lucky to get 16%
of their principal. There is no free lunch.
Coupled with a slower velocity of money (see last issue), tighter bank
lending standards and increased consumer savings (less spending puts less
pressure on prices) and you have increasing deflationary pressure.
This deflationary environment is the back-drop for the rest of my 2002
predictions.
What are some of the effects? For starters, US corporations will continue
to have difficulty raising prices. That means reduced profit margins and
lower profits, which is precisely what we are seeing in the current data.
Lower profits mean lowered capital spending. Capital spending has been one
of the main culprits in the current recession, and while we will see a
rebound in the second half of 2002, it will not be robust. Tepid is the
word that comes to mind. We are at decades long historic lows in capacity
utilization. Typically, businesses do not buy products (capital spending)
to increase capacity unless they see an increase in demand or a way to
lower production costs for existing demand.
Lower profits mean more unemployment. The historic correlation is tight.
Everyone acknowledges unemployment is going to at least 6% and some think
7% or more. I think 7% is quite possible, which (in the grand scheme of
things) is not all that bad, unless you are in the 7%. It means that 93% of
us are still working. The problem is that it is likely to linger for a
while.
That means a continuing deterioration in credit card debt problems,
bankruptcies and such. That is also not the environment for a consumer led
recovery (see more below).
Lower profits and lower employment mean lower tax revenues and increased
expenses at all levels of government. While the US government can run a
deficit, states and cities cannot. That means the level of pain in state
capitals this year will be at all-time highs. There have been major
surpluses in many states for several years. This surplus was spent and
budgets increased. Now the surpluses are gone, and state and local
politicians are going to have to deal with the short-fall "cold turkey."
You will see lots of headlines about this, and the level of negative
rhetoric will increase. Prediction: in most places and for most people,
your state and local taxes will increase, more than offsetting the peanut
sized tax cut at the federal level.
Recovery? What Recovery?
Let me state up-front that I think we will "recover" in the latter half of
the year. But for reasons I will now outline, the recovery will be weaker
than normal.
The case that market cheerleaders (analysts, brokers and money managers)
offer for a robust recovery is dependent upon historical precedent. The US
has had 7 recessions since World War II. 6 of the 7 have seen dramatic
rebounds in the 8 quarters after the recession was over. The one exception
was in 1991, where the recovery was slow but sure.
On one hand, Douglas Lee, writing in Barron's, is typical of the
cheerleader genre. Arguing that there is still a New Economy, he looks at
several factors which will produce a stronger than usual recovery. He calls
it a "Super-V". Of course, he mentions the Fed rate cuts and the huge
increase in the money supply. Then the ".first stage of the recovery will
be powered by a reversal of the inventory correction that helped push the
economy into recession..The second stage of the Super-V recovery will be
powered by both the fiscal stimulus already built into government policy
and a resumption of capital spending.(One should not take the US consumer
for granted, but consumer balance sheets are in excellent shape, confidence
has been surprisingly resilient, energy prices are down, housing prices are
stable and more tax breaks are on the way. These factors should offset the
negatives from a soft labor market.)." (Barron's.)
And on the other hand we go to Dr. Kurt Richebacher, who sees no such
recovery (Please remove sharp objects from your vicinity prior to reading
further.):
"Manifestly, the economic and financial excesses that have built up in the
U.S. economy during the past four to five boom years are the worst in
history. The last time the U.S. economy experienced protracted weakness was
from 1989 to 1993. Taking the actual credit expansion as a measure of
excess, we note that during the second half of the 1980s, total credit
(private nonfinancial and financial) in the United States had increased
$3.4 trillion. In the second half of the 1990s, it expanded by more than $9
trillion.
"What is still normal in an economy with such an insane credit explosion?
We presume, nothing. Looking only at the most obvious and the most
spectacular, unsustainable imbalances is more than shocking, it is
frightening: grossly overvalued equities, near-zero personal savings, the
monstrous trade deficit, steeply rising trillions of foreign debts, a
hugely overvalued dollar, badly weakened corporate balance sheets, the
lowest corporate profitability in the whole postwar period, and a financial
system that is founded on the most fantastic leverage.
"This is a virtual Pandora's box of interrelated and interdependent
bubbles, and the one thing that is keeping all these bubbles afloat is the
illusion of an imminent V-shaped recovery and blind faith in the magic of
Mr. Greenspan.
"Who or which demand component could possibly lead the predicted U.S.
economic recovery? Rising capital spending by debt-laden corporations
confronted with collapsing profits? Or higher spending by the debt-laden
consumer confronted with huge wealth losses in the stock market, rising
employment and stagnating or shrinking disposable income? Nobody can say
for sure what exactly is going to happen; yet one thing is beyond any
doubt: the V-shaped U.S. economic recovery is impossible." (The Richeb„cher
Letter, January 2002)
I think that pretty well sums up the bear case.
Let's look at the cheer-leader case. First, where is the evidence that rate
cuts are making any difference? I distinctly remember Jim Cramer of
TheStreet.com telling us to not fight the Fed last winter. Rate cuts, he
said, will avoid the recession and explode the stock market. He was wrong.
Anecdotally, my banker tells me the last 2% of rate cuts have done nothing
for his business except make his CD customers mad at him as they roll over
at 2% rates.
Rate cuts do matter, and are part of the reason why things did not get
worse, but we need more than just rate cuts to stimulate growth. If it was
that easy, we wouldn't need to guess about where the economy is going. Rate
cuts are just one component of a very complex picture.
Secondly, the key problem for Greenspan and company is that long-term rates
have mystifyingly (at least to me) not come down in tandem with short term
rates. While short term interest rates are lower, bank lending is
demonstrably tighter and thus not helping the economy. It is actually
hurting those who are dependent upon CD's for income.
What little fiscal stimulus we have had is a drop in the bucket and is not
of the type which would stimulate an economy. Majority leader Daschle, in a
fit of pure partisanship, has postponed a real stimulus package. If one
does get passed, it will be a case of too little, too late. It takes time
for these things to work their way through to the economy.
Lee predicts an explosion in inventory re-building. But from what source?
New sales are still less than inventory reductions. Further, much of the
recent growth was supplied from technology investments. But the latest CIO
(Chief Information Officer) poll from Dr. Ed Yardeni shows companies are
cutting way back on tech expenditure growth. Most do not expect to see a
rebound in tech expenditures until the second quarter or later. This is
consistent with other polls from other industries I have seen. While this
will inevitably change, in a just-in-time production world, inventories
adjust to meet current sales levels. They do not "explode". Inventories may
rise, but they will not go back to 2000 levels for a long time.
cont. |
