“The greatest obstacle to discovery is not ignorance; it is the illusion of knowledge.”
– Daniel Boorstin
The quote above is about the discovery of new knowledge. But the statement certainly applies to forecasting the current world economy and stock markets. Those who say they know are peddling the illusion of knowledge.
Those who say they know are guessing. The global economy is facing a situation it has never faced before, i.e., a global deflationary debt downturn coupled with unrestrained monetary and fiscal stimulus programs and growing protectionism in virtually all the world’s major economies. Plus a huge announced swing in prevailing economic ideology in the United States. There is no textbook model for what will happen next. So everybody is guessing.
So I Too Am Going to Guess
But first, several points of fact:
1. In his campaign and in his first hundred days, President Obama has laid out exactly what he intends to do. You may not agree with these plans but no one can accuse this Administration of bait and switch duplicity. Obama and the Democrats are openly committed to more regulation, higher taxes, a universal health care program that will require massive and yet unspecified Federal funding and an expensive alternative energy program. Like it or hate it, this is a dramatic reversal of the reliance on markets, lower taxes and deregulation bias of the Reagan years. The Administration’s “stimulus” by and large isn’t really a stimulus. It is a major multiyear increase in the role of government in the US economy. By definition if the Federal government is expanding relative to GDP there must be a relative contraction in the share of the private sector. Call it crowding out or whatever you want. Estimates are that Federal expenditures (not counting Federal Reserve financed bailouts), now running at approximately 20 percent of GDP, will quickly rise to at least 30 percent assuming enactment of the Administration programs. This is a matter of ideological taste. The Obama Administration and its supporters obviously prefer this expanded role of government. Time will tell. Perhaps the alternative energy program will bring major breakthroughs and turn out to be a winner. Perhaps Americans will be willing to pay the enormous cost of a single payer universal health care program and that this will somehow improve medical productivity and not result in price controls and the stagnation of drug innovation. Perhaps. But to me these programs don’t look like good news for investors.
2. The Obama program must be paid for by higher taxes. Short term, in the face of an economic downturn the higher taxes are an “anti-stimulus”. Longer term, higher taxes, along with printing money, is the mechanism that the expanded role of the government will require to muscle for itself the needed resources. From a short term perspective, anyone who took the typical Keynesian oriented Econ 101 knows that either decreasing taxes or increasing government spending can serve as stimulus. Yes many Keynesians and most politicians prefer increasing government spending to lowering taxes. But nobody to my knowledge had ever argued that increasing taxes serves as a stimulus. It’s a little early to jump on the Administration for raising taxes. After all, they haven’t done it – yet. But it’s no secret that that is what is being planned for the years ahead. Higher income taxes on high earners, higher estate taxes, cap and trade taxes, uncapped payroll taxes, higher taxation of foreign source income. The list goes on. This Administration apparently never met a tax it didn’t like. Furthermore, the bottom 50% of the population are being scheduled to pay no income taxes, providing them with every incentive to vote for politicians who promise more benefits and higher taxes on the other 50%. Add this to the reality of state and local taxes rising. New York State for example is adding a surcharge on high income earners (of which New York this year will have considerably fewer.) When asked if this made economic sense, New York Governor David Paterson cheerfully replied “Nothing about this (his budget) makes sense.”
3. Let’s not deceive ourselves about the current state of the economy. Regardless of how well the stock market has done lately or how rosy the forecast for the economy several quarters out, the US economy at the moment couldn’t be worse. Unemployment is now officially at 8.9% as of April and if you add in people working part time and people who have given up looking, then you get an unemployment rate of 15.8 %, the highest since this series was started in 1994. Conventionally defined unemployment is easily going to rise above 10% before this year is over. Weekly unemployment claims have bounced back up again. The American consumer – the over indebted steam engine of recent economic growth – has suffered a massive erosion of wealth as house prices are well on their way to a what could turn out to be a decline of over 35% from peak to trough. There are at least 2.4 million in unsold houses according to economist A Gary Shilling. Excess inventories are the enemy of prices. Rising unemployment will continue depress consumer spending. Commercial real estate and credit card nonperformers are going up. The shot in the arm from the recent tax refunds will soon fade. Nonperformers at banks and other financial institutions to keep on rising for at least the next year.
4. The so-called stress test for the major 19 banks is a political exercise not to be trusted. The stress test came up with a total capital raise of $ 75 billion and expected worst case losses of $599 billion. These are “Washington” numbers, as the market just discovered when it learned the banks had negotiated down their capital raising requirement. It’s the number that the regulators figured was the maximum that the market would give these banks, not the capital they really need. The numbers fall far short of what the normally politically correct IMF has estimated for American bank losses or the even more pessimistic estimates of widely respected NYU economist Noriel Roubini. Of course how much capital to banks really “need” when the government stands behind them regardless of what they do. The fact is that a good part of the banking system has been “GSEd”. It raises capital on government guarantees of all sorts, much as Fannie and Freddie did for years. Those guarantees are the capital.
5. Sorry for the partisan tone. But the United States is engaged in the worst imaginable sort of industrial policy. Losers are rewarded and propped up to compete against winners. In the Chrysler bankruptcy proceedings secured debtor’s rights have been trashed as the politically favored class (the unions and the government) move to the front of the line. However with Washington deciding the auto makers’ product mix, one wonders whether the government assistance is a poison chalice. Chrysler and GM receive government aid so they can compete against unsubsidized Ford, Toyota, Honda, and Nissan. Chrysler is to be taken over by Fiat (!!) because Fiat— a failure in the US market in the 1980s and on death’s door itself a few years ago – produces politically correct small cars. Imagine. Chrysler is to be rescued by Italian technology! I know I should look at the good side. At least in this case, America has shed its fear of foreigners. Hopefully we won’t be reading books about the coming Italian takeover of American industry. But what will come next? Perhaps the Central Bank of Zimbabwe can give advice to the Fed on printing money. Will Americans have to be “induced” by ever more favorable subsidies and tax incentives – under the cover of “noble” environmental goals of course – to buy government approved GM and Chrysler green cars? It is the same in the banking industry. Subsidized Citibank and Bank of America compete against unsubsidized HSBC. HSBC itself, whose origin is the colonial China coast, is British domiciled but not quite a local British boy. So HSBC has maintained a higher capital level all along since it might not be sure which central bank might be counted to come to its rescue. HSBC – too global nowadays for its Hong Kong roots and not 100% British. No such worries for Citibank or the Royal Bank of Scotland. Moral hazard big time. If you know you have a central bank behind you, why carry a lot of capital? Was it so long ago that the Americans used to complain that Boeing was unfairly disadvantaged by European subsidies to Airbus? And by the way Obama can’t be totally blamed for the botched bank bailout. Remember Hank Paulson?
So What’s Next for the Markets?
As readers of this letter know, so far this year I’ve been too negative on the stock market. We’ve had one huge rally. Yes the economy died as I expected but the market went up anyway.
But that’s water over the damn. Let’s start with bonds and the dollar. There has been considerable debate among economists whether US interest rates will eventually go higher or lower. Probably the prevailing view is that the huge monetary stimulus that the Fed has undertaken plus the unprecedented expansion of Federal expenditures along with unending trillion dollar per year plus deficits will result in an eventual increase in US rates once the current deflationary wave exhausts itself. The contrary view has been that the current deflationary wave is so powerful that rates will stay down for a multiyear period. Japan is cited as an example of government bond rates going ever lower in the face of government monetary and fiscal stimulus. Since we’ve never quite been in this situation before, nobody really knows.
My own view: eventually US government rates will go up and the dollar will get weaker. Huge borrowing will be necessary along with tax increases. Even if inflation doesn’t come back, the US government as mentioned has to feed ever expanding programs. But it’s hard to imagine that this process will not involve at least some increase in inflation. The Fed has gotten in the habit of printing huge amounts of high powered money. All the worse for bonds.
Therefore: Buy gold and silver and hope the government doesn’t eventually try to confiscate them. Avoid long term bonds. As for the US stock market, my view is that there won’t be much of an economic recovery by year end and that more downside surprises may be in stored. So I’m still not excited about the US stock market. Although it is just possible that the big monetary expansion may serve to push up stocks in spite of the economy.
A Note on China
The prevailing view in Asia is that China rather than the US will lead the world out of the current economic downturn. It’s easy to see the logic. China has a real stimulus program designed to pump money immediately into the economy. And no American talk of raising taxes or class warfare. The American program as discussed overall is an ideologically driven long run plan to transform the American economy coupled with a botched (bipartisan) bank bailout. The Chinese banks didn’t get caught in the American financial system’s toxic asset fiasco. And China is now the largest lender to the United States.
The short run impact of the Chinese program seems clear. There has been a pickup in Chinese economic activity after exports fell off a cliff in the fourth quarter. Whether the Chinese plan will have any positive long run effects remains to be seen. The bulk of the Chinese stimulus seems to be going to infrastructure which should have a positive effect on productivity. But the government directed 25% yoy increase in bank loans in the first quarter does not inspire confidence. It’s definitely not the way to run a banking system. Throwing massive amounts of bank loans at a problem will inevitably result in a rise in nonperforming loans.
But China may get off easy here. In coming years productivity for the Chinese economy will benefit automatically as hundreds of millions of people migrate from zero productivity farm jobs in the countryside to what will have to be higher productivity jobs in the cities. That along with the Chinese work ethic and high Chinese savings rate makes up for a lot of financial sector inefficiencies, overinvestment in state enterprises and restricted information flows in the Chinese economy. There’s still a lot of low hanging fruit to be harvested in China. America gets no such benefit – there’s nobody left to leave the farms. America’s productivity growth must come from greater efficiency and enhanced technology only. Allowing more immigration of skilled immigrants would also do a lot for productivity but that doesn’t look to be happening.
