insight 1012b

August 2012 A. Gary Shilling's INSIGHT 1

INSIGHT (ISSN 0899-6393) goes to press by the third business day of the month. © 2012 A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield, NJ07081-1020. Telephone: 973-467-0070. Fax: 973-467-1943. E-mail: [email protected]. Web: www.agaryshilling.com.President: A. Gary Shilling. Editor: Fred T. Rossi. Research Associates: Colin Hatton and Luke Henninger.All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Material contained inthis report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such. This is not asolicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a long or shortposition in any security, option or futures contract of the issue(s) mentioned in this report.

The Grand DisconnectIn This Issue

October 2012

A Grand Disconnect has developed between weak and weakening economiesworldwide and optimistic investors, hooked on continuing massive monetary andfiscal stimuli. The U.K. and the eurozone are in recession, the U.S. economy isin or close to decline and a hard landing is unfolding in China. Softness in thesethree paramount areas is dragging down the rest of the world’s economies.

So Bad, It’s Good

Yet most investors seem totally unconcerned over the unfolding global recession.In fact, the globe’s economies and financial markets have become so dependenton monetary and fiscal bailouts and investors so enamored by them that theyseem to have forgotten the dire circumstances that continue to precipitate thesestimuli. Many market participants yearn for conditions that are so troubled thatcentral banks and governments will be spurred to more ease. “Oh, goodie,goodie,” they seem to say, “the economies are so weak that the Fed or theEuropean Central Bank or the Chinese government must act,” with positiveimplications for stocks. Conditions are so bad that it’s good for my equityportfolio.

On September 7, the U.S. employment numbers for August were announced andthey were very weak. Payrolls rose only 96,000 from July, the fourth sub-100,000rise in the last five months (Chart 1) and far below the 200,000 or so needed tokeep up with population growth and potential new job-seekers. July’s rise wasrevised down significantly by 22,000 and June’s by 19,000 after a previousreduction of 16,000.

Real annual rate GDP growth was also just revised down from 1.7% to 1.3%.Among GDP components, consumer spending on durable and nondurable goodsas well as services, investment in structures, equipment and software, exports andimports, and federal defense and nondefense spending were all revised down.

The unemployment rate dropped from 8.3% to 8.1% in August, but only becausediscouraged unemployed people gave up looking for work and dropped out ofthe labor force. Those leaving the labor force included 195,000 who lost theirjobs and 226,000 who were already unemployed. Those not in the labor force

Volume XXVIII, Number 10 October 2012

The Grand Disconnect 1A Grand Disconnect has openedbetween weakening economiesworldwide and optimistic investors,hooked on continuing massive monetaryand fiscal stimuli. The U.K. and theeurozone are in recession, the U.S.economy is in or close to decline and ahard landing is unfolding in China.Yet most investors seem totallyunconcerned. Instead, many yearn forconditions so troubled that central banksand governments will be spurred tomore ease. This “risk on” attitude andlow interest rates also are pushinginvestors further out the risk spectrumthan they realize.Near total reliance on monetary andfiscal stimuli, with little regard forfundamental economic performance, is anew phenomenon. Until quite recently,faith in government action was strongbut coupled with the belief it would soonre-establish rapid economic growth.Many hoped for a magic fiscal ormonetary bullet. But slow and nowfaltering global economic growthindicates that huge monetary and fiscalefforts are being more than offset bythe gigantic deleveraging in the privatesector. To restore normal global growthwill simply take time, the five-to-sevenyears for deleveraging to be completed.With emphasis now on the opiate ofgovernment stimuli, more and more isneeded to keep investment addictssatisfied. Recent market actionssuggest that QE3 is a classic case ofbuy the rumor, sell the news.This Grand Disconnect is profoundlyunhealthy—and a reconnection isinevitable. We see a shock causingfinancial markets to nosedive andreconnect with faltering globaleconomies. Candidates include the U.S.economy going off the fiscal cliff, thelikely hard landing in China, energy pricespikes due to Middle East turmoil, S&P500 operating earnings dropping or theglobal fallout of a collapsed Euro bank.

Investment Themes 22Summing Up 23

Commentary—How To SlashHospital Waiting Time 32

Economic Research and Investment Strategy

A. Gary Shilling’s INSIGHT

2 A. Gary Shilling's INSIGHT October 2012Telephone: 973-467-0070

[email protected]

but desiring jobs jumped by 437,000 to7.0 million, or 2.9% of the population,the highest in this lackluster recoveryfrom the Great Recession. Employmentis still 4.7 million below the pre-recessionpeak.

The economic recovery officially beganover three years ago in June 2009, andin past upswings, the unemploymentrate often rose as rapid job creationattracted many new job-seekers.Interestingly, this time, job openings arerising although still well below pre-recession heights (Chart 2) .Nevertheless, lack of needed skills,choosy employers in an uncertain worldand labor immobility have restrainedthe growth in new hires.

That weak U.S. employment reportconvinced investors that the Fed wouldembark on Quantitative Easing 3, ashinted earlier by Chairman Bernanke.And when the Fed announced QE3 onSeptember 13, the S&P 500 climbed1.6%

A Shift of Emphasis

Near total reliance on monetary andfiscal stimuli, with little regard forfundamental economic performance—except hoping it’s weak enough to spurmore government action—is a newphenomenon. Until quite recently, faithin government action was strong butcoupled with the belief it would soon re-establish rapid economic growth. Earlier, in radio, TV andprint interviews on the economies and financial marketshere and abroad, we’ve invariably been asked, “Whatmonetary or fiscal actions will restore rapid economicgrowth soon?” The belief was that some magic bullet wouldrestore growth to the salad days of the 1980s and 1990s.

We always replied that there was no magic bullet. Theimmense monetary and fiscal stimuli, as measured by the$1 trillion-plus annual federal government deficits and the$3.3 trillion in quantitative easing to date and $1.5 trillionexcess bank reserves at the Fed as well as other governmentactions probably made the economy and financial marketsbetter off than otherwise. Nevertheless, the slow and nowfaltering global economic growth indicated that these hugeefforts were being more than offset by the giganticdeleveraging in the private sector. The only thing that

CHART 1Nonfarm Payroll Employment

Source: Bureau of Labor Statistics

Last Point 8/12: 96monthly change; thousands

2007 2008 2009 2010 2011 2012-1000

-800

-600

-400

-200

0

200

400

600

-1000

-800

-600

-400

-200

0

200

400

600

CHART 2Job Openings and Hires


Last Points 7/12: hires 4,229; openings 3,664thousands

Dec-00 Aug-02 Apr-04 Dec-05 Aug-07 Apr-09 Dec-102000

2500

3000

3500

4000

4500

5000

5500

6000

2000

2500

3000

3500

4000

4500

5000

5500

6000

Hires

Job Openings

would restore normal global growth, we argued, was time,the five-to-seven years it would take for deleveraging to becompleted.

This search and hope for a magic bullet now seems to beabandoned. Does it mean that many now agree with us thatthere is none? In any event, emphasis is now almost solelyon the opiate of government stimuli, and more and moreis probably needed to keep investment addicts satisfied.Chronologically, the announcements by the Fed and ECBdiscussed earlier had less and less effect on the S&P 500.And recent market actions suggest that QE3 is a classic caseof buy the rumor, sell the news.

But what more can be done? The Fed’s QE3 commitmentto purchase $40 billion in mortgage-backed securities permonth is open-ended, and scheduled to last until the current

October 2012 A. Gary Shilling's INSIGHT 3Telephone: 973-467-0070

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8.1% unemployment rate drops to theFed target range of probably 5% to 6%and job creation is robust. That willprobably take a number of years.Meanwhile, excess bank reserves willcontinue to leap. At the same time, theECB’s purchase of short-termsovereigns from troubled eurozonegovernments will push up its already-exploded assets (Chart 3).

Inevitable

The Grand Disconnect between slippingglobal economies and robust equities,driven by never-ending monetary andfiscal stimuli, is profoundly unhealthy—and a reconnection is inevitable. Ofcourse, there is that slim, remote,inconsequential, trivial probability thatour forecast of deleveraging, ofcontinuing global economic weaknessand of recession is dead wrong, and thatall the government stimuli and otherforces will revive economies enough tojustify current investor enthusiasm. Wedoubt it, however, as a review of thecurrent state of worldwide economicaffairs suggests.

Sluggish America

The U.S. economy is sluggish at bestand may already be in recession. Wewon’t know for sure for months,quarters, even years from now when allthe data revisions are in. Even thoughearlier post-World War II recessionswere much shallower on average than the 2007-2009slump, their recoveries were decidedly more robust.

As discussed in previous Insights, in the past, four cylindersfired in the recoveries to get the economic car out of therecessionary ditch. This time, only one fired. Theelimination of excess inventories gave the usual spur to theeconomy even before modest rebuilding, as more andmore sales came from new production and less and lessfrom liquidation of old inventories (Chart 4).

The second economic spur, housing activity, usuallyrevives robustly, even before recoveries start, as the Fedreverses gears from credit restraint to ease once it sees arecession in clear prospect, and interest rates throughoutthe spectrum fall. Low rates, however, have not revivedhousing this time in the wake of the collapse in construction

CHART 4Inventories-to-Sales Ratio

Source: U.S. Department of Commerce

Last Points 7/12: mfg. 1.27; retail 1.39; whlsale 1.21seasonally-adjusted

Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-121.10

1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.60

1.65

1.10

1.15

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.60

1.65

Manufacturing

Retail

Wholesale

CHART 3Total European Central Bank Assets

Source: European Central Bank

Last Point 9/21/12: 3,050€ billion

Jan-07 Dec-07 Dec-08 Nov-09 Nov-10 Oct-111000

1200

1400

1600

1800

2000

2200

2400

2600

2800

3000

3200

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3200

and prices (Chart 5) that commenced in 2006.

Many believe housing activity has bottomed, but few thinkit will revive enough to drive the economy any time soon.In contrast, we continue to believe that single-family houseprices remain vulnerable due to excess vacant units, whichwe number at 1.5 million over and above normal workinglevels, as detailed in past Insights.

Third, employment normally revives rapidly after recessions,especially those before the 1990-1991 decline when manymore were employed in manufacturing and called back totheir previous jobs soon after the economic downturn andexcess inventory liquidation were over (Chart 6) .Globalization and the shift away from manufacturing jobshave tempered employment recoveries since then, but therevival from the Great Recession decline has been veryweak in light of the huge drop in jobs, as noted earlier.


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Wages and Incomes

American business in the last threeyears of recovery has had little ability toraise prices, and sales volume growthhere and abroad has been minimal. Sothe route to higher profits has beenthrough cost-cutting, especially laborcosts, which are the biggest containablecategory for most firms. Note the leapin corporate profits’ share of nationalincome to a postwar record (Chart 7),but as usual, employee compensation’sshare was the mirror image.

Not only has cost-cutting restrained jobcreation but also wages and salaries.Real wages are moving lower. Realmedian household income in 2011 wasdown 9% from its 1999 peak and 8%since the Great Recession started in2007 as income polarization persists(Chart 8).

Indeed, even with declining real wagesand median income, consumers areworking off their huge debt loads (Chart9), although a major part of the declineis due to debt charge-offs andwritedowns. The household saving ratehas been volatile due to the effects ofthe earlier tax rebates and cuts, but istrending up after falling from 12% inthe early 1980s to less than 1% (Chart10). Young Americans—who haveseen their parents and other older peoplein recent years lose their jobs and homesand delay retirement—are cutting theirspending, increasing saving andpreparing for their own retirements.

Chronic Saving

As we’ve discussed in detail in pastInsights, the debt repayment and savingrate rose will probably persist for years.The recent volatility of stocks, with twoof only five declines of over 40% since1900 occurring since 2000 (Chart 11),had destroyed the belief that portfoliogains will make saving from currentincome unnecessary. Indeed, individualinvestors continue to withdraw moneyfrom U.S. domestic equity funds (Chart12), even after accounting for the

CHART 5Case-Shiller 10-City House Price Index

Source: Standard & Poor's

Last Point 7/12: 154.9seasonally-adjusted

Jan-87 Mar-91 May-95 Jul-99 Sep-03 Nov-07 Jan-1260

80

100

120

140

160

180

200

220

240

60

80

100

120

140

160

180

200

220

240

CHART 6Payroll Employment During Recessions and Recoveries

T=official NBER trough Source: Bureau of Labor Statistics

peak employment month=100

0 10 20 30 40 50

Months from Employment Peak

93

94

95

96

97

98

99

100

101

93

94

95

96

97

98

99

100

101

Avg. Recession 1947-82

1990-91 Recession

2001 Recession

2007-09 Recession

T90-91

T01

T07-09

TAvg

CHART 7Corporate Profits and Employee Compensation

Source: Bureau of Economic Analysis

Last Points 2Q 2012: corp. profits 13.9%; employee comp. 62.1%as a % of national income

1947-I 1959-III 1972-I 1984-III 1997-I 2009-III 56%

58%

60%

62%

64%

66%

68%

70%

7%

8%

9%

10%

11%

12%

13%

14%

15%

Compensation of Employees - left axis

Corp. Profits with IVA and CCAdj - right axis


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counter flows into exchange-tradedfunds (Chart 13). So far this year,investors have pulled $137 billion fromU.S. equity mutual funds but only offsetit with $89 billion purchases of ETFs.

With home equity withdrawn and fallinghouse prices, home equity of the averagemortgagor has dropped from almost50% of their abode’s value in the early1980s to 20.5% and 24% are underwater, with the mortgage principalexceeding the house’s value. So thissource of funding for oversizedspending has evaporated.

As covered in our August 2012 Insight,we believe that the earlier mini-U.S.consumer spending splurge in excess ofincome growth (Chart 14) is over, andthat households are beginning toretrench. With no other economicsector able to sustain economic growth,a moderate recession is now under wayor about to start. Concrete evidence isfound in the three consecutive months—April, May and June—of declining retailsales (Chart 15), the first decline forthree months in a row since October-November-December 2008 in themidst of the Great Recession. Declinesof three or more consecutive monthshave occurred 29 times since data beganin 1947. In 27 of the 29, the economywas in a recession or within three monthsof its start. A rebound after threemonths of decline, such as occurred inJuly and August, is typical and did notreduce the high likelihood of a recession.

More Weakness

Other indicators of U.S. economicweakness include small businessoptimism, which remains at recessionarylevels and deteriorating big businesssentiment.

Industrial production also droppedsharply in August, with declines inmanufacturing, mining and utilities.Furthermore, new orders for durablegoods went off the cliff with a huge13.2% drop in August from July and6.7% from August 2011.

CHART 9Household Debt (consumer plus mortgage)

Source: Federal Reserve

Last Point 2Q 2012: 108.9%as a % of disposable personal income

1952-I 1964-I 1976-I 1988-I 2000-I 2012-I30%

40%

50%

60%

70%

80%

90%

100%

110%

120%

130%

30%

40%

50%

60%

70%

80%

90%

100%

110%

120%

130%

CHART 10U.S. Personal Saving Rate


Last Point 8/12: 3.7%seasonally-adjusted annual rate

Jan-59 Jan-67 Jan-75 Jan-83 Jan-91 Jan-99 Jan-070

2

4

6

8

10

12

14

16

0

2

4

6

8

10

12

14

16

CHART 8Share of Aggregate Income

Source: Census Bureau

Last Points: 2011by income quintile

1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 20113%

4%

5%

6%

7%

8%

9%

10%

11%

12%

Lo

west

and S

eco

nd Q

uin

tile

14%

16%

18%

20%

22%

24%

26%

Third

and F

ourth

Quin

tile

42%

43%

44%

45%

46%

47%

48%

49%

50%

51%

52%

Hig

hest

Quin

tile

1st Quintile (lowest)

2nd Quintile

3rd Quintile

4th Quintile

5th Quintile (Highest)


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Inventories

Weakness in durable goods orders willprobably be reflected in higher producerinventories, and rising inventories arealways linked to economic declines.When orders and sales drop,manufacturers, wholesalers and retailerscannot initially tell whether it’s a randomfluctuation or the beginning of asignificant downturn. So they don’tslash their own orders and productionquickly and inventories mount. That’salready the case with retailers andwholesalers, and will probably back upto manufacturers soon.

Getting rid of unwanted inventoriesconstitutes a significant part of thedecline in economic activity in recessions.Notice (Chart 16) that in post-WorldWar II recessions, it has accounted for21.1% of the decline in real GDP in the1957-1958 recession up to 126.4% inthe 1960-1961 slump. Interestingly,there is no clear declining trend despitethe fact that services, which by definitionare consumed as produced and have noinventory component, are an ever-risingshare of GDP while inventory-relatedgoods’ share falls (Chart 17).

The U.S. economy, then, is weakeningand may already be in recession. Youwouldn’t know it, however, from therecent strength in the stock market.

QE3

On September 13, the Fed announcedQE3. Subsequent reports indicate thatit took Chairman Bernankeconsiderable one-on-one discussionsand cajoling to get all but onepolicymaker to agree to the open-endedpurchase of $40 billion of federal agencymortgage-backed securities per monthuntil unemployment rates return to theFed ’s range for the normalunemployment rate, 5% to 6.3%. Thosepolicymakers don’t see the current 8.1%rate dropping into that range until theend of 2014.

By then, the Fed would have bought

CHART 11S&P 500 Declines Over 40%

Peak Date Peak Level Trough Date Trough Level % Decline

Sept. 1929

Feb. 1937

Jan. 11, 1973

Mar. 24, 2000

Oct. 9, 2007

June 1932

Apr. 1942

Oct. 3, 1974

Oct. 9, 2002

Mar. 9, 2009

31.30

18.11

120.24

1527.46

1565.15

4.77

7.84

62.28

776.76

676.53

84.8%

56.7%

48.2%

49.1%

56.8%

CHART 12Net Domestic Equity Mutual Fund Flows

Source: Investment Company Institute

Last Point 8/12: -15.5monthly; $ billion

2007 2008 2009 2010 2011 2012-50

-40

-30

-20

-10

0

10

20

-50

-40

-30

-20

-10

0

10

20

CHART 13U.S. Domestic Equity Fund Flows

2008 2009 2010 2012*Net Mutual Fund Flows

Net ETF Flows

Total

* through June 2012

-94,881

38,369

-56,512

-28,076

-248

-28,324

-134,418

47,580

-86,838

-52,322

22,736

-29,586

$ millions

2011-148,195

115,696

-32,499

Source: Investment Company Institute and ETF Industry Association


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around $1,060 billion of these securitiesissued by Fannie Mae, Freddie Mac andother government-sponsoredenterprises, compared with the $1.75trillion it purchased in QE1 and $850billion in QE2. Since there were $2,258bill ion of these agency securitiesoutstanding as of the second quarter,the Fed would have bought 46% ofthem by the end of 2014. And thecentral bank would own them all, a verydisruptive prospect for credit markets,if it took another 2.5 years to reach theFed's unemployment rate target rangein mid-2017. In this year so far, the Fedhas bought in the open market $360billion of Treasurys maturing in 7 to 30years, the equivalent of 65% of the$556 billion gross issuance of suchobligations.

The prospect that the Fed will ownthem all if it sticks to its current planisn’t all that far-fetched. As we’ve beennoting for some months, at the rate thatprivate sector deleveraging is takingplace (Chart 18), it will take another fiveto seven years to return to norm in2017 to 2019.

Chronic Unemployment

The deleveraging started with thefinancial crisis in 2008, so now we’realmost five years into it. Another fiveto seven years would total about adecade, the normal length of recoveryafter a major financial crisis, accordingto Carmen Reinhardt and KennethRogoff’s book, This Time Is Different:Eight Centuries of Financial Folly.

Meanwhile, our forecast of acontinuation of about 2% annualaverage real GDP growth implies highand rising unemployment rates. Chart19 shows the trade-off in the post-World War II era between the year-over-year change in real GDP byquarters and the year-over-year changein the unemployment rate.

Obviously, all the data points don’t lieon our fitted curve but the fit is good,as indicated by the 0.69 R2. Reading off

CHART 14Personal Consumption and Disposable Personal Income


Last Points 8/12: PCE 113.8; DPI 111.5June 2009=100

Jan-07 Nov-07 Sep-08 Jul-09 May-10 Mar-11 Jan-1294

96

98

100

102

104

106

108

110

112

114

94

96

98

100

102

104

106

108

110

112

114

Personal Consumption Expenditures

Disposable Personal Income

CHART 15Retail Sales

Source: Census Bureau

Last Points 8/12: total 11.2%; ex autos 9.9%month/month % change; seasonally-adjusted annual rate

Aug-10 Jan-11 Jul-11 Jan-12 Jul-12-10%

-5%

0%

5%

10%

15%

20%

-10%

-5%

0%

5%

10%

15%

20%

Total Retail and Food Service Sales

Retail and Food Service Sales ex. Autos

CHART 16Inventories In Recessions

Recession Real GDP Peak-to-Trough Decline % Due to Inventories1948-19491953-19541957-19581960-19611969-19701973-1975

19801981-19821990-1991

20012007-2009

112.5%29.8%21.1%

126.4%115.7%45.8%47.2%31.2%49.2%64.2%31.7%

-1.8%-2.6%-3.7%-1.6%-0.6%-3.2%-2.2%-2.7%-1.4%-0.3%-4.7%


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the curve, a 2% real GDP growthimplies a chronic rise in theunemployment rate by a bit over onepercentage point per year. In otherwords, the current 8.1% rate would riseto 9.1% in August 2013, to 10.2% inAugust 2014, to 11.3% in August 2015,etc.

Obviously, no government, left, rightor center, can tolerate high andchronically rising unemployment, socontinuing slow growth will continue topressure Washington for job creationwith the resulting high federal deficits.In any event, our forecast of persistentlyslow economic growth and highunemployment indicates that the Fedcould end up owning all the outstandingagency securities and then some, if itsticks to its plan, a highly unlikelyoutcome. So QE3 isn’t really open-ended, with our forecast.

With its September 13 QE3announcement, the Fed also said itwould continue through year’s endOperation Twist, its program of buyinglong-term Treasurys while selling short-term government securities. It will alsocontinue to reinvest its maturingmortgage-related securities, so its totalholding of long-term securities will riseabout $85 billion per month throughyear’s end. Furthermore, the policycommittee extended its 0-0.25% rangefor the short-term federal funds rate itcontrols by six months, at least throughmid-2015.

Why?

Why did Bernanke push through QE3?Sure, the Fed has a dual mandate topromote full employment as well asprice stability, but QE3 on top ofOperation Twist, QE2 and QE1 and allthe Wall Street rescue measures theFed took in 2008 have pushed thecentral bank deep into the realm offiscal policy, compromising its fiercely-defended independence. Also, the open-ended and unprecedented nature ofQE3 might suggest that Bernanke haslost control.

CHART 17Goods and Services


Last Points 2Q 2012: goods 28.2%; services 64.7%as a share of GDP

1947 1959 1971 1983 1995 200725%

30%

35%

40%

45%

50%

55%

60%

65%

70%

25%

30%

35%

40%

45%

50%

55%

60%

65%

70%

Goods

Services

CHART 18Ratio of Sector Cumulative Debt and Equity Issuance to GDP


Last Points: 2Q 2012

1952 1958 1964 1970 1976 1982 1988 1994 2000 2006 20120%

20%

40%

60%

80%

100%

120%

140%

0%

20%

40%

60%

80%

100%

120%

140%

Nonfinancial Corporate

Household

State and Local

Federal Government

Financial

CHART 19Year/Year Change in Unemployment Rate as a Function of

the Year/Year Change in Real GDP1Q 1949-2Q 2012


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Furthermore, the effectiveness ofprevious quantitative easing isquestionable, so why do more? Despitethe $3.3 trillion of long-term securitiesthe Fed has bought so far, economicgrowth is marginal at best andunemployment remains very high. Ofcourse, we’ll never know what wouldhave happened otherwise. An old historyprofessor of ours used to say that thereare no “ifs” in history. History isn’t acontrolled experiment where you canchange one baffle in the maze, run therats through again and see which waythey turn this time.

In his August 31 Jackson Hole speech,made before the September 13 QE 3announcement, Bernanke defended theFed’s aggressive policy. He stated theasset purchases so far reduced the yieldon 10-year Treasury notes by 0.8% to1.2% and said, “These effects areeconomically meaningful.” He alsonoted the rise in stocks during thosequantitative easings (Chart 20). AndBernanke said that a Fed study thatfound that QE1 and QE2 had raisedoutput by 3% and increased privatepayrolls by 2 million from what wouldhave occurred otherwise “whilemitigating deflationary risks.”

Well, maybe so, but what we know forcertain is that the Fed’s asset purchaseshave had limited effect on the normalfinancing process. Sure, when the Fedbuys Treasurys or mortgage-backedsecurities, the seller has the resultingmoney to spend or invest elsewhere.Meanwhile, he deposits the funds in abank, which increases the bank ’sreserves at the Fed. In normal times,these funds are lent and re-lent by banksin the fractional reserve system, and thenet result is that every dollar of reservesturns into about $70 of M2 moneysupply.

But currently, banks are reluctant tolend except to the most creditworthyborrowers who aren’t much interestedin borrowing, despite negative realinterest rates (Chart 21). So, sinceAugust 2008, before quantitative easing

CHART 21Real and Nominal Federal Funds Target Rate

Source: Federal Reserve, Bureau of Labor Statistics and A. Gary Shilling & Co.

Last Points: nominal 10/3/12 0.125%; real 8/31/12 -1.45%

Jan-07 May-08 Sep-09 Feb-11 Jun-12-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

Nominal Target Rate

Real (Nominal less yr/yr change in CPI) Target Rate

CHART 20S&P 500 and Quantitative Easing

Source: Thomson Reuters and A. Gary Shilling & Co.

Last Point 10/3/12: 1,451

Jan-07 Oct-07 Aug-08 May-09 Mar-10 Dec-10 Oct-11 Jul-12600

700

800

900

1000

1100

1200

1300

1400

1500

1600

600

700

800

900

1000

1100

1200

1300

1400

1500

1600

QE1

+42%

QE2

+24%

Op. Twist

+20%

Greece 1

Greece 2 / Fed. Debt Ceiling

Euro Crisis /Fiscal Cliff

QE3

CHART 22M2 Money Supply and Total Bank Reserves

Source: St. Louis Federal Reserve

$ billion; seasonally-adjusted


7500

8000

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9000

9500

10000

10500

0

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M2 Money Supply - Left Axis

St. Louis Adjusted Reserves - Right Axis

M2 Reserves

Aug. 08 7743 97.5

Aug. 12 10058 1626.5

Difference 2315 1529.0


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but when the Fed started to expandbank reserves, they’ve risen $1.5 trillionwhile M2 has increased $2.3 trillion(Chart 22). That’s a 1.5 multiplier, farbelow the normal 70. Another way oflooking at this is to note the piling up ofexcess reserves, the difference betweentotal and required bank reserves at theFed, which now total about $1.5 trillion.

Credibility And Withdrawal

Another issue that might have givenBernanke pause in pursuing QE3 isstrains on the Fed’s credibility. In hisJackson Hole speech, he said a “potentialcost of additional securities purchases isthat substantial further expansions ofthe balance sheet could reduce publicconfidence in the Fed’s ability to exitsmoothly from its accommodativepolicies at the appropriate time. Even ifunjustified, such a reduction inconfidence might increase the risk of acostly unanchoring of inflationexpectations, leading in turn to financialand economic instability.”

This strikes us as a serious threat.Bernanke has stated that the Fed couldeasily get rid of excess reserves byagreeing, in a 15-minute policycommittee phone call, to sell securitiesfrom its vast $2.8 trillion portfolio. Butlet’s put the economy five to sevenyears down the road when deleveragingis completed and real growth movesfrom about 2% per year to its long-runtrend of 3.0% to 3.5%.

Even then, it would take at least severalyears to utilize excess capacity and labor,as indicated by the CommerceDepartment’s output gap (Chart 23).This gap is calculated from thedifference between current real GDPgrowth and growth potential of theeconomy, as estimated by Departmenteconomists.

In any event, when Wall Street gets theslightest hint that the Fed is thinkingabout removing the excess liquidity,interest rates will leap and the danger ofan economic relapse will seem very real.

CHART 23Output Gap


Last Point 2Q 2012: -6.01%as a share of potential GDP

1949-I 1961-I 1973-I 1985-I 1997-I 2009-I -10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

CHART 2410- and 30-Year Treasury Bonds

Source: Thomson Reuters

Last Points 10/3/12: 10-yr. 1.62%; 30-yr. 2.82%

Jan-07 Oct-07 Jul-08 May-09 Mar-10 Dec-10 Sep-11 Jul-121.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

5.5%

10-Year Treasury Yield

30-Year Treasury Yield

CHART 25Spanish and Italian 10-Year Government Bond Yields


Last Points 10/3/12: Spain 5.806%; Italy 5.099%

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Nov-10 Aug-11 May-123.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

Spain

Italy


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Political pressure on the Fed might beintense, charging it with taking away thepunch bowl before the party even getsstarted.

Echoes of 1937-1938?

No doubt, historians in the crowd wouldrecall the 1937-1938 recession. It’shard to believe, but in 1936, with theeconomy a long way from full recoveryafter the 1929-1933 collapse anddeflation sill prevailing, the Fed andFDR worried about a return of rapidinflation. So they tightened monetaryand fiscal policy. Real GNP dropped11.4% in what was dubbed the RooseveltDepression, less than the 36.2% fall inthe Great Depression but more thantwice as much as the 4.7% decline in GDP in the recentGreat Recession.

Maintaining credibility in the Fed is obviously paramountfor a number of reasons. For one, it allows the Fed to buyhuge quantities of Treasurys without being accused offinancing the Treasury deficit, even if indirectly. In theOctober 2010-September 2011 fiscal year, the Fed boughtTreasurys equal to 77% of all those issued by the Treasury,and in this year to date, $360 billion of Treasurys maturingin 7 to 30 years, the equivalent of 65% of the $556 billiongross issuance. Still, these indirect purchases are quitedifferent than buying them directly since the sales by theTreasury and the purchases by the Fed are both conductedin open markets where investors price credibility. So far,faith in the Fed and the Treasury has not preventedTreasury yields from declining substantially (Chart 24).

In Europe, the ECB has bought the sovereign debts oftroubled countries and plans to buy more, as discussedearlier. Still, the credibility of Spain and Italy is so low thattheir yields have leaped (Chart 25). Financial credibility wasalso a very serious problem for the German Weimarrepublic where the central bank bragged that its prizedpossessions were two of the world’s fastest currencyprinting presses!

The Fed’s Objectives

Obviously, Bernanke & Co. felt that all these negatives willbe more than offset by the positives of QE3. By buyingmortgage-related securities, they hope to further drivedown mortgage rates to encourage refinancing and inducehome buying. But mortgage rates, along with other interestrates, have already declined tremendously without obvioussignificant impacts on housing activity. Many other factors

remain negative.

Lending standards have gone from almost nonexistent tostringent in the last few years, and many lack the now-necessary credit scores and downpayments. Theunemployed and those whose jobs are in jeopardy clearlyare out of the home-buying picture, regardless of mortgagerate levels. So too are those who are underwater on theirmortgages. And the desirability of homeownership hasreversed for many who now realize, for the first time sincethe 1930s, that house prices can and do fall.

Bernanke also hopes that those who sell mortgage-backedsecurities to the Fed under QE3 will use the proceeds to buyreal estate, stocks and other financial investments, pushingup their prices. This will make them feel wealthier sohouseholds and businesses will spend, invest and hire morepeople. “This is a ‘Main Street’ policy,” he said after theFed’s September policy meeting. “What we are about hereis trying to get jobs going.”

But note that in the sequence we just described, there arefive steps between the Fed’s purchase of securities and jobcreation, and one or more may fail to be taken. We believethis was largely true with earlier quantitative easing, despiteBernanke’s model results. Stocks rose for a while in eachinstance. So did commodities (Chart 26). But highergasoline and grocery costs squeezed consumer purchasingpower, and employment gains remain subdued. Higherfood and energy costs hurt the poor the most, ironically,folks that the Fed and the Administration care about. In2010, the latest data, the bottom fifth of households byincome devoted 27% of the spending on food and energywith the top fifth spent only 18%.

CHART 26Reuters/Jefferies Commodity Research Bureau Index

Source: Jefferies and Co.

Last Point 10/4/12: 306.6

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12100

150

200

250

300

350

400

450

500

100

150

200

250

300

350

400

450

500


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Homeowner Effects

Homebuyers certainly did not show theenthusiastic response to earlierquantitative easing that stockholders did,as shown by comparing the two priceresponses. This is significant sincehouseholds with large stock portfoliostend to have higher incomes, and theirspending is not affected significantly byportfolio value fluctuations. Chart 27shows the concentration of stockownership among high-incomehouseholds. Those in the top 10% byincome have average stock portfoliosthat were 52 times the equity ownershipsof the bottom 20% in 2010, the latestdata. In the top 20% of households byincome, 87% own stocks.

In contrast, lower-income householdsare much more likely to spend more ifthe value of their assets roses, but only13% of the bottom fifth by income ownstocks. Nevertheless, 37% of the lowestfifth owned their abodes, andhomeownership is much more evenlydistributed by income group (Chart 28).The average home value of the top 10%was only 5.3 times that of the lowest20% in 2010. Some 69% of householdsowned homes compared to 50% thatowned stocks, and the median value ofhomes was $170,000 compared to$29,000 median stockholding.

In any event, the relationship of realwealth on consumer spending is weakwith a correlation of only 57% going back to 1952. Therelationship to after-tax income is much stronger, 75%, butwith corporate cost-cutting and the limping economy,growth in disposable (after-tax) income has been minimalof late.

So if government policy intends to encourage householdspending by spurring their asset values, it’s much moreeffective to push up house prices than equity values. Theproblem for the Fed in doing so is that monetary policy isa very blunt instrument. The central bank can only moveinterest rates up or down and buy or sell Treasury andfederal agency securities. It’s up to the markets todetermine any follow-on effects on other asset purchasespending effects, etc. Sure, QE3 does involve homemortgage security purchases, but that’s as specific as theFed can get and, as noted earlier, the effects of previous

CHART 27Median Value of Direct and Indirect* Stock Holdings

1998 2001 2004 2010All families

percent of incomeLess than 2020-39.940-59.960-79.980-89.990-100

32.9

8.09.6

15.026.556.0

202.4

35.0

7.09.0

15.031.064.9

250.0

34.0

6.08.1

18.033.064.2

221.0

29.0

5.17.3

12.021.358.4

266.5

by income class; thousands of dollars

200725.0

5.09.5

12.019.045.1

135.0

* indirect holdings are mutual funds, retirement accounts and other marginal assetsSource: Federal Reserve Survey of Consumer Finance

CHART 28Median Value of Primary residence

1998 2001 2004 2010All families

percent of incomeLess than 2020-39.940-59.960-79.980-89.990-100

175.7

76.9109.8148.3192.2247.1494.2

131.0

69.285.2

101.2138.5186.4319.5

200.0

100.0120.0150.0215.0300.0500.0

170.0

89.0110.0135.0175.0250.0475.0

by income class; thousands of dollars

2007115.8

63.886.998.5

127.4158.7260.7

Source: Federal Reserve Survey of Consumer Finance

buying of mortgage-related securities on housing activityhave been limited.

Focused Fiscal Policy

In contrast, fiscal policy can be very focused. If Congressand the Administration want to help the unemployed, theycan increase unemployment benefit payments and extendthe time over which they can be received. But at present,fiscal policy is on hold, given the huge size of ongoingfederal deficits, political gridlock in Washington and theupcoming November election.

This is likely another reason the Fed adopted QE3—thepressure to “do something” in Washington amidst a falteringeconomy. The Fed at present is the only game in town, andit probably wants to demonstrate that it feels the country’s


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pain and is not hiding in its marbleheadquarters in Washington.

Furthermore, unlike a number of us,Bernanke does not believe that theGreat Recession left many unemployedwho lack the skills needed for availablejobs—the structurally-unemployedcarpenters and plumbers laid off whenresidential construction collapsed whocan’t easily shift to software engineering.In his Jackson Hole speech, Bernankesaid, “Although the recent recessionwas usually deep, I see little evidence ofsubstantial structural changes in[unemployment] in recent years.” So,as far as he’s concerned, all that’s neededto eliminate excess joblessness is moreaggregated demand, not massiveretraining for those who are retrainable.

Plosser Agrees

Federal Reserve Bank of PhiladelphiaPresident Charles Plosser agrees with uson the ineffectiveness of QE3 inreducing unemployment. He stated ina September 25 speech: “We are unlikelyto see much benefit to growth or toemployment from further assetpurchases. Conveying the idea thatsuch action will have a substantive impacton labor markets and the speed of therecovery risks the Fed’s credibility…. Iopposed the [policy] Committee’sactions in September because I believethat increasing monetary policyaccommodation is neither appropriatenor likely to be effective in the current environment. Everymonetary policy action has costs and benefits, and myassessment is that the potential costs and risks associatedwith these actions outweigh the potential meager benefits.”

After the speech, he told reporters, “It doesn’t make senseto say that there is a particular unemployment rate that wecan achieve. The problem with the labor market is thereare many things that affect employment and unemploymentthat are beyond the control of the Fed” such as technology,education attainment and tax rates.

Bernanke also pursued QE3 because he sees little evidenceof inflation, and indeed, the Fed’s favorite measure, theconsumer expenditures deflator excluding food and energy,rose 1.6% in August from a year earlier, below the Fed’starget of 2.0%. In his Jackson Hole speech, he noted,

“Inflation has remained near the [policy] Committee’s 2%objective and inflation expectations have remained stable.”Indeed, the spread between the yield on 10-year TreasuryInflation-Protected Securities and 10-year Treasury notes(Chart 29) suggests that investors aren't worried aboutserious inflation in the next decade.

Deflation Fears

Indeed, the Fed is much more worried about deflation thaninflation, and in his Jackson Hole speech, Bernanke saidthat central bank security purchases were “mitigatingdeflationary risks,” as quoted earlier. In deflation, evenzero nominal interest rates are positive in real terms, as seenrepeatedly in Japan (Chart 30). To create negative realrates, as at present (Chart 31), the Fed during deflation can’treduce the fed funds rate below zero—although recently,

CHART 30Japanese Real and Nominal Overnight Rates

Source: Bank of Japan

Last Points 8/12: real 0.6%; nominal 0.1%

Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11-4%

-2%

0%

2%

4%

6%

8%

10%

-4%

-2%

0%

2%

4%

6%

8%

10%

Nominal Overnight Rate

Real Overnight Rate (nominal rate less yr/yr change in CPI)

CHART 2910-Year Treasury - TIPS Spread and Yield


Last Points 10/3/12: 2.47; yield -0.83

Jan-03 Jan-05 Jan-07 Dec-08 Dec-10-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

10 Year Treasury - TIPS Spread

10 Year TIPS Yield


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short-term Treasury (Chart 32), Germanand Danish government security yieldshave dropped into negative territory.Investors were so zealous to hold themthat they were willing to pay for theprivilege. In any event, in time ofeconomic weakness, the Fed wantsnegative real rates, as at present, toencourage borrowers to borrow. Ininflation-adjusted terms, lenders arepaying borrowers to take the filthy lucreaway.

Furthermore, in deflation, the fed fundsrate is likely to remain close to zero, asat present. But the Fed would like it tobe far enough in positive territory thatit can cut it significantly in future timesof economic weakness in order tostimulate the economy.

Finally, the Fed fears that deflation, if itbecomes chronic as we continue toforecast, will spawn deflationaryexpectations. Declining prices willencourage buyers to wait for still-lowerprices. Their restraint sires excessinventories and unutilized capacity,which pushes prices lower. Thatconfirms expectations and convincesprospective purchasers to wait for still-lower prices. A self-feeding, downwardspiral of prices and economic activityresults.

Interestingly, this has not occurred inJapan during its two-decade-longdeflationary depression. Even thoughconsumer prices have been falling moreoften than rising since 1990 (Chart 33),deflationary expectations have notdeveloped. Of course, the Japaneseculture does differ from the American,so the Fed’s worry over deflationaryexpectations may be valid.

Help The Treasury

It’s interesting that some observersbelieve the Fed wants inflation andnegative real rates to reduce the burdenof the Treasury’s huge debt (Chart 34)by paying its holders negative realreturns. This is called “financialrepression.” We doubt this sinister

CHART 33Japanese Money Supply and Prices

Source: Bank of Japan and Statistics Bureau of Japan

Last Points 8/12: CPI -0.5%; M2 2.4%year/year % change

Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Yr/Yr Change in CPI

Yr/Yr Change in M2 Money Supply

CHART 31Real Effective Federal Funds Rate

Source: Federal Reserve and Bureau of Labor Statistics

Last Point 8/12: -1.57%effective fed funds - year/year change in CPI

Jan-55 May-63 Sep-71 Jan-80 May-88 Sep-96 Jan-05-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

CHART 32U.S. 1-Month Treasury Bill Yield


Last Point 10/3/12: 0.09%

Jan-11 Mar-11May-11Aug-11 Oct-11 Dec-11 Mar-12May-12Aug-12-0.02%

0.00%

0.02%

0.04%

0.06%

0.08%

0.10%

0.12%

0.14%

0.16%

0.18%

-0.02%

0.00%

0.02%

0.04%

0.06%

0.08%

0.10%

0.12%

0.14%

0.16%

0.18%


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motivation on the part of the Fed, andput the “financial repression” notion inthe same area of those who believe theFed is hyping its balance sheet and bankreserves to generate serious inflation inorder to slash the real value of federaldebt, again at the expense of governmentsecurity owners.

Distortions

Although we don’t see sinister motiveson the part of the Fed, that doesn’tmean its actions haven’t had distortingeffects on the economy. Near-zerointerest rates have created an unusualarray of winners and losers.

At a zero federal funds rate, the Fedcan’t cut it further in reaction toeconomic weakness. If deflationunfolds, it can’t push real rates negativein order to stimulate borrowing.Furthermore, the lack of response tonear-zero interest rates by lenders andborrowers is what pushed the Fed, andearlier the Bank of Japan, into the newworld of quantitative easing. This andother non-interest rate actions takenpreviously also has pushed the Feduncomfortably close to fiscal policyand threatened its independence, asnoted earlier.

As discussed earlier, we doubt that theFed in any way acted to ease the problemsof the federal debt and deficit .Nevertheless, low interest rates do keepthe cost of financing the debt low (Chart 35), even as it leaps.We wouldn’t suggest, of course, that these low financingcosts encourage Congress and the Administration to delaydealing with the mushrooming federal debt.

Regardless, after deducting its own operating expenses, theFed returns the interest it receives on the holding ofTreasurys and agency securities to the Treasury, helping tooffset the deficit. Bernanke noted in a recent speech that,in the past three years, the Fed has remitted $200 billion tothe Treasury. Central banking is a neat game. The Fedcreates money out of thin air, uses it to buy securities andthen sends the interest, after expenses, back to thegovernment. Can we get in on it?

Central bank rates close to zero also promoted the strangephenomenon of negative returns on short-term government

securities, as discussed earlier. Then there is the recentnegative 0.75% yield on 10-year TIPS. Of course, TIPSreturns are adjusted for inflation. If annual inflation overthe next decade turns out to be 2.5%, as forecast by thespread between 10-year TIPS and 10-year Treasury notes,the return on the TIPS would be just a bit below 2.5%annually.

Borrower Beneficiaries

The federal government, of course, isn’t the only borrowerbenefiting from low interest costs and negative real rates.Residential mortgagors, if they can qualify for loans,obviously are getting a break with 30-year rates at 3.4%.

Investment-grade corporations have been able to issuedebt and refinance at low rates, and many are doing so. InJuly, $75 billion were issued, a record for any July, at 3.2%

CHART 34Net Federal Debt Outstanding

Source: Office of Management and Budget

Last Point 2011: 67.7%as a % of GDP

1945 1955 1965 1975 1985 1995 200520%

30%

40%

50%

60%

70%

80%

90%

100%

110%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

CHART 35Federal Government Net Interest Payments

* net interest = interest payments to debt held by the public Source: Office of Management and Budget

Last Points 2011: interest/GDP 1.54%; interest/expenditures 6.38%

1948 1958 1968 1978 1988 1998 20081.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4%

6%

8%

10%

12%

14%

16%

Net Interest / GDP - left axis

Net Interest / Federal Govt Expenditures - right axis


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average yields, a record low andcompared with an average 7.2% overthe last 30 days. In the third quarter asa whole, $257 billion were issued, 64%more than a year earlier. To be sure,low corporate bond yields are partlydue to individual investors’ disdain forstocks and love of bonds, andinvestment-grade corporates also havesafe haven appeal.

Low interest costs as well as its taxdeductibility make it attractive to issuebonds instead of equity. Some entitiesare issuing century bonds. Last year,MIT, Norfolk Southern, BerkshireHathaway, P&G, Robobank Nederland,Coca-Cola and Motorola all locked upborrowing that doesn’t mature for 100years. In August 2011, the Universityof Southern California issued $300million in century bonds with a 5.25%coupon yield, compared with 3.4% yieldat the time on much shorter 30-yearTreasurys. The relatively small premiumfor another 70 years suggests that buyersof that issue agree with us in not fearinginflation for many years.

Another winner from low interest rates,and especially QE3, is agency securities.On the day QE3 was announced,September 13, Fannie Mae mortgage-backed securities with a 3% interestrate coupon jumped 1-10/32 points,outperforming the 10-year Treasurynote by 1-4/36 points. Normally, theperformance difference in a tradingday is less than 5/32 point. The Fed’s$40 billion per month purchase of agencydebt under QE3 is the equivalent of amajor part of the normal $140 billionmonthly issuance.

Dividends

Dividend-paying stocks have alsobenefited from low interest rates, despiteaverage yields over S&P 500 stocks ofonly 2.1% (Chart 36). Furthermore, thecollapse in stocks in 2008 and the factthat the S&P 500 index showed zero netgain from 1998 through 2011 and nogain in 2011 alone have steered manyinstitutional and individual investors to

CHART 36S&P 500 Dividend Yield and Payout Ratio

Source: Standard & Poor's

Last Points 2Q 2012: payout ratio 31.7%; dividend yield 2.08%

1947 to present

1947Q1 1957Q1 1967Q1 1977Q1 1987Q1 1997Q1 2007Q120%

30%

40%

50%

60%

70%

80%

90%

100%

1%

2%

3%

4%

5%

6%

7%

8%

Dividend Payout Ratio - left axis

Dividend Yield - right axis

CHART 37Six-Month CD and Money Market Fund Yields

Source: Crane Data, Bloomberg and Federal Reserve

Last Points 10/3/12: money market 0.06%; CD 0.35%

Oct-06 Jul-07 May-08 Mar-09 Dec-09 Oct-10 Jul-11 May-120%

1%

2%

3%

4%

5%

6%

0%

1%

2%

3%

4%

5%

6%

Avg. 7 Day Annual Yield on Money Market Funds

Annual Yield on Six-Month Certificate of Deposits

CHART 38Minimum Balance Required to Avoid a Fee

Source: Bankrate

Last Point 2012: $723non-interest checking

2007 2008 2009 2010 2011 2012$0

$100

$200

$300

$400

$500

$600

$700

$800

$0

$100

$200

$300

$400

$500

$600

$700

$800


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stocks that pay high, sustainable andincreasing dividends as well as to bonds.They want income here and now asopposed to pie-in-the-sky capitalappreciation out in the wild blue yonder.

Investors are putting increasing pressureon corporate managements to paydividends, and in August, S&P 500companies paid out a record $34 billion.This pressure is also reflected in stockbuybacks. Although they aren’t alwayscompleted—since 1985, 25%weren’t—the times of actual purchasesis uncertain and buybacks sometimessimply offset new issuances toemployees, S&P 500 companies haveannounced $429 bill ion in equitybuybacks for 2012, down, however,from $555 billion last year.

Companies such as Microsoft and Wal-Mart that no longer have growth stockimages are under heavy pressure to paydividends. Wal-Mart’s dividends haverisen 5.3 times in the past decade andthe dividend yield is now an average2.1% while the stock price has onlyrisen 50% in that time.

Interestingly, the total return on dividend-paying stocks beat nonpayers in everyyear since 2000 except 2003 and 2009.If $10,000 had been invested innondividend-paying stocks in 1979, itwould have been worth $250,000 in2010, but the same amount in dividend-payers would have risen to $413,000.Part of this superior result, of course, is the compoundingof re-invested dividends.

The Losers

It amazes us that in his Jackson Hole speech, and elsewhereas far as we know, Chairman Bernanke emphasized thebeneficiaries of low interest rates but never even mentionedthe losers. Neither, to our knowledge, have any keyAdministration official or member of Congress. But near-zero interest rates are causing considerable distortions andoutright harm to many.

Think about savers who are receiving trivial returns ontheir bank and money market accounts (Chart 37) thatwould be negative if fund managers weren’t waiving fees.Furthermore, free checking accounts are fading. Banks

and thrifts, facing low interest earnings, have increased thesize of the required balance on checking accounts that payno interest to $723, on average, up 23% in the last year(Chart 38). The average fee on non-interest checkingaccounts jumped 25% to $5.48 per month, also a record.The percentage of non-interest checking accounts that arefree of charges dropped form 76% in 2009 to 45% in 2011to 39% today. Banks are also reacting to new federalrestrictions on debit card and overdraft charges and feesthat will reduce their annual revenues by $10 billion. Oncorporate cash deposits over $50 million, Bank of NewYork Mellon began charging a fee in August 2011.

Furthermore, many savers are deserting money marketfunds (Chart 39) for the safety of FDIC-insured accounts(Chart 40). This chart also has M2 velocity of money, theratio of M2 to GDP in inverted form to show that the

CHART 39Total Money Market Fund Assets

Source: Investment Company Institute

Last Point 9/20/12: 2.58$ trillion

Jan-08 Dec-08 Dec-09 Nov-10 Nov-112.4

2.6

2.8

3.0

3.2

3.4

3.6

3.8

4.0

2.4

2.6

2.8

3.0

3.2

3.4

3.6

3.8

4.0

CHART 40M2 Money Velocity and FDIC-Insured Deposits

Source: FDIC and St. Louis Federal Reserve

Last Points 2Q 2012: deposits 8.4%; velocity 1.58

Mar-86 Mar-91 Mar-96 Mar-01 Mar-06 Mar-11-5%

0%

5%

10%

15%

20%

25% 1.5

1.6

1.7

1.8

1.9

2.0

2.1

2.2

FDIC Insured Deposits (year/year % change) - left axis

M2 Velocity of Money - right axis (inverted)


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money is just sitting in accounts, despitenext to no returns in nominal terms anddistinctly negative returns in real terms.In Europe, the ECB in July announcedthat it would cut its deposit rate forbanks to zero and benchmark lendingrate to 0.75% (Chart 41). With rates thislow, managers of money market fundstotaling $60 billion have closed theirfunds to new investors. Many werealready offering returns well under 1%.

Will Americans be discouraged by lowinterest rate returns and save less, orsave more to reach lifetime goals? Webelieve the latter, which is one morereason why we expect the householdsaving rate to climb back to doubledigits. At the same time, low interestreturns in conjunction with volatilestocks and huge losses on owner-occupied houses are forcing manyvastly-undersaved postwar babies towork well beyond their expectedretirements. Sure, better health forseniors and increasing life spans arealso factors, but the percentages ofmen and women over 65 and in thelabor force are rising rapidly (Chart 42).And as seniors retain their jobs, thereare fewer openings for younger peopleand less advancement for those inbetween.

With the Fed now intending to keepshort-term interest rates near zerothrough 2015, and probably longer asdeleveraging keeps the economysubdued and unemployment high, what can savers do?Hope for the arrival of deflation, which will push realinterest rates from negative to positive?

Squeezed Banks

Despite these efforts to increase fees, banks are alsosuffering from near-zero interest rates. That’s even thoughthey are paying next to nothing on deposits, which continueto jump as savers stampede for liquidity and safety. Oneserious problem is the relatively flat yield curve, anchoredby zero federal funds rates on the short end and pusheddown for longer maturities, where banks normally lend, bydeclining Treasury yields.

This pressure on spread lending couldn’t come at a worsetime for banks. Starting in the 1970s, banks and other

CHART 41Central Bank Rates

Source: The central banks

Last Points: 10/3/12

0%

1%

2%

3%

4%

5%

6%

Jan-07 May-08 Sep-09 Feb-11 Jul-120%

1%

2%

3%

4%

5%

6%

U.S. Fed. Funds Target Rate

ECB Repo Rate

UK Bank Rate

BOJ Call Rate

CHART 42Labor Force Participation Rate for People Over 65


Last Points 8/12: male 23.2%; female 14.6%seasonally-adjusted

Jan-48 May-56 Sep-64 Jan-73 May-81 Sep-89 Jan-98 May-0610%

15%

20%

25%

30%

35%

40%

45%

50%

6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

Male - left axis

Female - right axis

financial institutions leveraged themselves up dramaticallyas they moved beyond traditional bank spread lending to allsorts of exotic and highly profitable activities, includingspecial investment vehicles and other off-balance sheetinvestments, securitization of subprime mortgages,proprietary trading and exotic derivatives. But the financialcrisis to which these activities contributed immensely hasresulted in rigorous enforcement of previously loosely-pursued regulation; new rules, principally the Dodd-Franklaw that proscribed proprietary trading and other activities;stockholder pressure to reduce risks; and bank CEO firingsand embarrassments for current financial institutionmanagements. Banks are being busted back to less-risky,normally low-profit spread lending.

Bank yields on assets are in a distinctly downward trend(Chart 43), which will no doubt persist as the Fed continuesto keep short rates at zero. U.S. banks also have considerable


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exposure to the sovereign debt troublesin Europe. Of their global total exposure,24% is in the eurozone and it’s 44% ifthe U.K. is included. European banksare in worse danger due to their heavyownership of the sovereign debt oftroubled eurozone countries, as we'lldiscuss later.

Many U.S. banks still have unresolvedproblems with troubled mortgages thatinvestors who bought them claim weremisrepresented as to quality.

Zeal For Yield

While some investors are pursuing thesafe haven of FDIC-insured deposits,others, unsatisfied with low nominaland negative real returns, are movingout on the risk spectrum in their zeal foryield, whether they understand theadditional risk they are incurring or not.Bernanke, in his Jackson Hole speech,acknowledged this possibility. “Someobservers have raised concerns that, bydriving longer-term yields lower,nontraditional policies [quantitativeeasing] could induce an imprudent reachfor yield by some investors and therebythreaten financial stability.” But hedismissed this threat, saying, “We haveseen little evidence thus far of unsafebuildup of risk or leverage.”

We see lots of potentially “unsafebuildups.” Consider the rush into junkbonds, depressing their yields andspreads vs. Treasurys (Chart 44). Somuch money has poured into below-investment grade debt that it’s takenreal skill of late to default (Chart 45). Inthe third quarter, junk-rated companiessold $94 billion in debt compared to$25 billion in the third quarter of 2011.But the global recession will hypedefaults even though many low-ratedcompanies have a cushion of safetyfrom prefunded debt.

Zeal for yield has pushed the returns onjunk municipal bonds to 3.15 percentagepoints above investment-grade issues,the lowest gap in two year. These bondsare usually issued by quasi-governmental

CHART 43Yield on Bank Assets

Source: FDIC

Last Points 2Q 2012: large banks 3.9%; small banks 4.6%total interest income / earning assets

2005-I 2006-I 2007-I 2008-I 2009-I 2010-I 2011-I 2012-I3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

3.5%

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

Banks with more than $1 billion in assets

Banks with less than $1 billion in assets

CHART 45High-Yield Bond Default Rates

Source: Ed Altman and Brenda Kuehne/NYU Salomon Center

Last Points 2Q 2012: quarterly 0.37%; moving avg. 1.85%

1989 1992 1995 1998 2001 2004 2007 20100.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Quarterly Default Rate - left axis

12 Month Moving Average - right axis

CHART 44Junk Bond Yields and Spread vs. Treasurys

Source: Bianco Research LLC and Bloomberg

Last Points 10/3/12: yield 7.10%; spread 4.68%

Jan-07 Oct-07 Aug-08 May-09 Mar-10 Jan-11 Oct-11 Aug-120%

5%

10%

15%

20%

25%

0%

5%

10%

15%

20%

25%

Junk Bond Spread vs 20 Yr Treasurys

Junk Bond Yield


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bodies to finance schools, nursing homesand other facilities. They depend on therevenues generated, and aren'tguaranteed by municipal governments.

Other junk-like securities have appearedto satisfy investors’ zeal for yield. Closed-end funds offered by CornerstoneAdvisors provide huge “distributionyields” of about 22% of net asset value.But most of that extraordinary returncomes not from savvy investments but,in earlier years, from a return of investorassets and now from funds raised byrights offerings to existing shareholders.In 2008 and 2009, 93% of totaldistributions were a return of capital. Soinvestors simply are sending their ownmoney in and then having most of itreturned. Nevertheless, some investors who don’t read theprospectus’ fine print may think “distribution yields” arereal earnings. And Cornerstone charges 2.5% of assets peryear for this round tripping.

No Decoupling

Ever since our study of China in 2007, before the GreatRecession substantiated our view (“The Chinese MiddleClass: 110 Million Is Not Enough,” Nov. 2007 Insight),we’ve maintained that decoupling ranks with free lunch inthe nonexistent department. Export-led developing countriessimply can’t grow independently of Europe and the U.S.,which directly and indirectly buy the vast majority of theirexports.

Now, the decoupling theory once again has been disproved.Just look at how emerging market stocks, anticipating aglobal slowdown or recession, have underperformed theS&P 500 in the last year (Chart 46).

But that hasn’t slowed down yield-happy investors as theymove into sovereign debts of small Eastern European andother countries. Serbia’s 51% debt-to-GDP ratio is wellbelow those of Western Europe and its inflation-adjustedTreasury bonds yield exceeds 10%. The average debt-to-GDP ratio for the 27-country EU was 83% at the end ofthe first quarter. Spain’s government expects an 85.3%ratio this year and 90.5% in 2013. Hungarian bond yieldsare down from 10% last year but still run about 7%. Incontrast, Barclays Global Treasury Universal index, whichis heavily weighted toward large countries, yields 2.7%.

An important reason that small markets have large bondyields is because they tend to be illiquid, especially in timesof strain. This was seen clearly in the Asian and Russian

CHART 46Emerging Market and Domestic Stocks

Source: MSCI and Thomson Reuters

Last Points 10/3/12: MSCI -13.8%; S&P 500 14.1%return since 1/3/11

Jan-11 Mar-11May-11Aug-11 Oct-11 Dec-11 Mar-12May-12Aug-12-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

MSCI Emerging Markets Index

S&P 500 Index

debt crises of the late 1990s. The joke at the time was thatan emerging market is one you can’t emerge from in anemergency!

Commodities

As for commodities, we continue to regard them asspeculations, not an asset class with a strong upward pricetrend. As discussed in last month’s Insight, we’re well awareof all the time-worn reasons that commodity prices just mustgo up in the long run, going back to the Rev. Malthus.There are only so many tons of minerals in the earth’s crustand they’re more and more expensive to recover. There’sonly so much arable land to grow food for the world’sexploding population. Diets will be upgraded to containmore meat as countries develop, requiring more crops tofeed the animals. More and more people in developingcountries will soon be driving cars that take metals to buildand energy to propel and cement for the roads they'll travelon.

Peak Oil

Crude oil has been the darling of the commodity-shortagecrowd, and when its price rose to $145 per barrel in July2008, many became convinced that the world would soonrun out of oil.

As we discussed in “Shortages vs. Human Ingenuity” (Jan.2012 Insight), human ingenuity and substitutes have alwaysovercome shortages quickly, regardless of how permanentthey appeared. New extracting techniques slash the cost ofmineral production. Caterpillar just introduced a miningshovel that lifts 120 tons, the equivalent of five pickuptrucks, and Joy Global’s new entry is even bigger, 135 tons.Still, the dump trucks they fill require three scoops from


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Joy’s huge shovel.

Agricultural productivity leaps as nationsdevelop better seeds and fertilizers areused on larger fields that utilize efficientmechanized equipment, while improvedbreeding and medical care reduce thecost of producing meat. The advent ofplentiful natural gas from shale, thecollapse in U.S. prices and new crude oilfinds has shattered the theory of a near-peak in global energy output.

Furthermore, for the last 150 years,during which the U.S. and then Japanrose to become major economies andusers of commodities, real prices havebeen in a declining trend (Chart 47).Sure, the Civil War, World War I andWorld War II created temporarydemand spikes and the oil shocks in the1970s slashed supply. But the relatedprice spikes were overcome quicklywith real commodity prices falling backto their long-term declining trend.

U.K.

The U.K. has the same huge gulf betweeninvestor enamor over quantitative easingand a weak economy, but only more so.In mid-2010, the then-newConservative-led governmentembarked on a noble experiment, leadingthe fiscal austerity wave among majorcountries. It planned huge cuts ingovernment spending of £81 billion byfiscal 2014-2015 with average cuts ingovernment department budgets of 19% over five years. The hope was that reductions in government spendingwould energize the private sector to the point that it morethan made up the cuts, overall economic activity would leapand with it, government tax collections. So the net effectwould be a reduction in the government deficit from £10billion, or 9.4% of GDP, in fiscal 2010-2011 to less than£2 billion, or 1.5% of GDP, in 2015-2016.

Most of the planned tax cuts have already taken effect, andthe pace of reducing the corporate tax rate has beenspeeded up. By April 2014, it will be 22%, down from 28%two years ago and the lowest of G-7 nations. But only about30% of the spending cuts proposed in 2010 for the fouryears ending in March 2015 have been implemented.

(continued on page 24)

CHART 47Real U.S. Commodity Prices

Source: Bianco Research, Bureau of Labor Statistics and Historical Statistics of the United States

Last Point 8/12: 132.0CRB index deflated by CPI

1774 1814 1854 1894 1934 19740

200

400

600

800

1000

1200

1400

0

200

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British Recession

Meanwhile, with net exports dropping, a weak constructionsector, consumers concentrating on paying down theiroversized mortgages rather than spending and the austerityprogram depressing consumer and business outlays, arecession is well under way and deepening, with the thirdconsecutive drop in real GDP in the second quarter (Chart48). U.K. manufacturing activity also continues to fall(Chart 49). With the weak economy and delayed governmentspending cuts, government borrowing in the five monthsthrough August is 22% higher than a year earlier, and thegovernment's targets for borrowing and government debtreduction are in question.

Nevertheless, investors are concentrated on the Bank of

CHART 48U.K. GDP

Source: U.K. Office for National Statistics

Last Point 2Q 2012: -1.8%qtr./qtr. % change; seasonally-adjusted annual rate

2007 2008 2009 2010 2011 2012-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%


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INVESTMENT THEMESOur Investment Themes section reflects the positions that are in or being considered for our managed portfolios. We may addor delete portfolio positions in the course of the month, but those changes will not be shown in Insight until the following report.

Treasury bonds (favorable) The rally in Treasurysresumed in March as a safe haven in a sea of trouble andin response to slowing economic growth and looming globalrecession. The likelihood that inflation fears will turn soonto deflation worries also helped. The yield on 30-yearTreasurys actually reached our 2.5% target, the 2008 post-Lehman low, in early June. A 2.0% yield is possible aseconomic and financial conditions deteriorate.

Income-producing securities (favorable) As manyinvestors favor income over problematic capital gains,included are stocks of utilities, drugs and telecoms with high,safe and rising dividends. But all stocks are vulnerable toa likely bear market. Also, investment-grade corporate andmunicipal bonds and some Master Limited Partnerships areattractive.

The dollar vs. the euro and Australian dollar. Also theDollar Index (favorable) The buck is the world's safehaven. The eurozone financial crisis remains unresolvedand the recession there deepens. Australia has become acaptive mineral supplier to faltering China.

Rental apartments (favorable) have gained favor by thosewho can't afford home ownership and are discouraged byfalling house prices. Their stock prices seem overblown, butdirect ownership of rental apartments may still be attractive.

Medical Office Buildings (favorable). The aging postwarbabies, the 2010 health care law and the migration ofphysicians from private practice to hospital employmentwill promote robust, steady growth in this real estate sector.But government regulations can be disruptive.

North American energy (favorable) Americans havedecided to reduce dependence on imported energy fromhigh-risk foreign areas. We like conventional energyinvestments including natural gas, on- and off-shore drillingand Canadian oil sands. Natural gas prices appear to havebottomed, and pipelines are attractive. New nuclear facilitiesmay be postponed in the wake of the earthquake and

tsunami in Japan. Renewable energy is problematic since itdepends heavily on unpredictable government subsidiesamidst federal cost-cutting. Ethanol suffers from drought-sired corn price leaps.

Developed country stocks (unfavorable) With a hardlanding in China and the resulting negative effects oncommodity exporters, a major recession in Europe and astrong dollar, earnings of U.S. multinationals will be hurt. Amoderate recession in the U.S. will also damage corporateprofits despite more cost-cutting in response. We look for$80 per share in S&P 500 operating earnings over a comingfour-quarter period and a bottom P/E of 10.

Homebuilders are unattractive if house prices tumble aswe forecast.

Your house, second home or investment single-familyhouses aren't attractive. Excess inventories are likely topush prices down another 20% over the next several years.

U.S. major and regional banks (unfavorable) Majorbanks are being bereaved of proprietary trading and otherprofitable activities and are being busted back to less-lucrative spread lending. Regional banks suffer from weakloan demand and bad real estate loans.

Junk securities (unfavorable) Despite recent pre-borrowingfrom yield-hungry investors, default rates are likely to leapin the global recession we foresee while junk prices drop.

Developing country stocks (unfavorable) China is closeto a hard landing. She and other emerging exporters arevulnerable to economic weakness in the U.S. and Europe.

Commodities (unfavorable) The commodity bubble startedto break in early 2011 due to a prospective hard landing inChina and the global recession. Copper is already downsubstantially and excess inventories in China loom.

Deletions: The yen remains a safe haven, so we'redropping our unfavorable position for now.

Unresolved eurozone financial woes have spilled into economies there, and a European-wide recession is well underway.With tight economic policy in China and falling exports, the hard landing we forecast is unfolding and being anticipatedby falling commodity prices. Huge deficits and gridlock in Washington have curbed sizable U.S. fiscal stimuli. Theeuphoria over the Fed's QE3 will probably end with a shock, but the response so far is weak. A global 2012 recessionseems likely to provide that shock and benefit of our quartet of investment strategies: long Treasury bonds, short stocks,short commodities and long the dollar.


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Summing UpU.S. stock markets rose to near-five-year highs early inSeptember before drifting generally downward towardsmonth’s end as eurozone fears reared its ugly head,concerns lingered about the strength of the U.S. economyand China’s economy continued to weaken. Spain, inparticular its ailing banks and the country’s credit rating,was a major area of focus last month, and the economythere continued to fall at a “significant pace” in the thirdquarter, in the words of the Bank of Spain.

Finishing off a solid third quarter, the Dow Jones IndustrialAverage, S&P 500 index and Nasdaq all rose last month butcompleted September off their highs. Overseas marketssaw similar performances.

The dollar fell last month against the euro and gainedslightly vs. the yen. Treasury rates rose slightly last month.

If at first you don’t succeed, try, try again—and again. Inthe wake of another weak employment report, the FederalReserve after its September policy meeting announcedQE3—its intention to buy $40 billion worth of mortgage-backed bonds each month in an effort to boost the jobsmarket. The central bank said the purchases wouldcontinue “for a considerable time after the economicrecovery strengthens.” The Fed also lowered its expectationsfor economic growth this year, forecasting GDP growth of1.7%-2.0%, down from the 1.9%-2.4% estimate it issuedin June.

Consumer prices rose 0.6% in August after being flat forfour months. The increase was driven by higher fuel costs(energy prices up 5.6% and gasoline up 9%). CPI is up1.7% year-over-year. Core CPI rose 0.1% in August (year-over year, it’s ahead 1.9%). Producer prices rose 1.7% inAugust, led by a 6.4% rise in energy prices and a 13.6%increase in gasoline prices. PPI is up 2% year-over-year.Core PPI was up 0.2% in August (year-over-year, it’s ahead2.5%). The core personalconsumption deflator, the Fed’sfavorite inflation barometer, hasrisen just 1.6% from August 2011through August 2012, safely belowthe Fed’s 2.0% target.

Crude oil prices briefly touched$100 per barrel in mid-Septemberamidst the Libyan consulate attacksand widespread protests elsewherein the region before sliding back tothe lower $90s at month’s end.

The final revision of second quarter GDP showed a gainof 1.3%, down from the original +1.7% estimate and lessthan half the fourth quarter 2011’s 4.1% gain. Personalincome rose 0.1% in August while spending was up 0.4%,due mainly to higher energy prices, not increased consumerenthusiasm. As a result, the personal saving rate declinedto 3.7% from 4.1% in July.

Retail sales rose 0.9% in August, the biggest increase in sixmonths and boosted greatly by spending on cars and ongasoline. Car and truck sales weighed in at a 14.5 millionunit annual rate, the strongest month since 2009. Ex autos,retail sales were up 0.8%.

The jobs picture continued to be weak, with nonfarmpayrolls increasing by just 96,000 in August. The nationalunemployment rate declined to 8.1% from 8.3%, but thedrop was the result of people dropping out of the laborforce. Revisions showed July’s payroll increase was 141,000(vs. the original 163,000) and June’s gain was 45,000 (vs.64,000 originally reported). Further revisions late in themonth showed that job gains in the 12 months throughMarch 2012 were stronger than first estimated, with some400,000 more jobs being added than first reported.

Housing starts rose 2.3% in August, with single-familyhomes accounting for nearly three-fourths of activity. Newhome sales fell 0.3% in August from July, but July’s datawas revised upward to a level that was the highest sinceApril 2010. Sales, though, rose 28% from August 2011.The median price of $256,900 was 17% higher than a yearearlier while unsold inventories now stand at a 4.5-months’supply. Existing home sales rose 7.8% in August to theirhighest level since May 2010. The median price of$187,400 was up 9.5% higher than a year earlier.

The S&P/Case-Shiller index of property values in 20 citiesrose for a fourth month, 1.2% in June, with 16 citiesshowing a year-over-year gain, led by a 17% advance inPhoenix. The National Association of Home Builders’

confidence index rose two pointsto 40 in September—the highestlevel since June 2006.

Consumer sentiment rose to 78.3in September from 74.3 in August,the University of Michiganreported. The Conference Board’sindex of consumer confidence roseto 70.3 in September from 61.3 inAugust.

Fred T. RossiEditor

INSIDE THE NUMBERS

Dow Jones IndustrialsS&P 500Nasdaq CompositeNikkei AverageFTSE 100Hang Seng

*through Sept. 28

Sept. 2012% Change*

Year-to-Date% Change

+0.6% +1.9%+4.3%+1.7%+1.3%-1.6%

+7.1% +11.9% +17.7%

+4.5%+2.5%+5.7%

10-yr. Treasury note$=¥€=$

Aug. 31Sept. 281.64

78.031.28

1.55%78.271.26


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England’s quantitative easing and otherstimulating programs, and stocks arerising on balance. In July, the centralbank hiked its asset purchase programfrom £325 billion to £385 billion, inview of the weak economy and inflationfalling back to the BOE’s 2% target andthreatening to go lower. The BOE hasbeen the most aggressive of major centralbanks in expanding its sheet since theglobal financial crisis commenced (Chart50).

Interestingly, after the BOE’s Septemberpolicy meeting, its governor, Mervyn A. King, said, indefending the decision not to cut its reference rate belowthe current record low 0.5%, that further reductions couldhurt some financial institutions and might becounterproductive. Well, at least one central banker thinksabout the effects of near-zero rates on interest receivers!

In July, the BOE and the U.K. Treasury started theFunding for Lending Scheme that allows banks and otherlenders to borrow from the BOE for a lengthy four yearsif they lend the money to businesses and households. Butmoney is fungible, so a bank could say it did so but cutlending elsewhere. Besides, cash-heavy British banks are sowary of making more bad loans that they're buying backtheir own bonds instead. Banks maintain that creditworthyborrowers are lacking, and buying their senior bonds back,even at premiums over issue prices, is a better investmentand reduces funding costs. Deleveraging at work!

Eurozone

As goes the U.S. and U.K., so goes theeurozone. The ECB has been floodingthat area with money, in part to pushinvestors into stocks. It has succeeded,with stocks rising in the past year despitethe deteriorating economies. EvenGreek stocks are up this year, by 15%.With corporate profits flat at best, thestock rallies are hyping price-to-earningsratios, especially in southern Europewhere profits are plummeting. P/Esthere are at four-year highs relative tonorthern European companies.

Last year the ECB returned its target

(continued from page 21)The Grand Disconnect CHART 49

U.K. Manufacturing Purchasing Managers Index

Source: Markit Economics

Last Point 9/12: 48.4

Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-1230

35

40

45

50

55

60

65

30

35

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45

50

55

60

65

CHART 50Central Bank Balance Sheets

May2007

September*2012

%Increase

Bank of England (£ billion)

Swiss National Bank (CHF billion)

Federal Reserve (US$ billion)

European Central Bank (€ billion)

403.1%

366.2%

213.1%

161.7%

399.51

492.54

2,806.19

3,049.54

79.42

105.65

896.13

1,165.36

* Swiss National Bank data is through August 2012; unlike the others, its data is released monthlySource: HM Revenue and Customs

rate to 1%, essentially ignoring its sole mandate to keepinflation under 2%, in view of the financial crisis that hasspilled over into the real economy. Then, in late 2011 andearly 2012, the ECB lent €1 trillion to 800 member banksat 1% for an unprecedented three years. Those banks inturn used the money to refinance their own debts and tolend to their home countries for deficit financing—after all,few others would lend to the Greek, Portuguese, Spanishor Italian governments. Those funds proved insufficient,and subsequently the European Union agreed to recapitalizeSpanish banks with €100 billion from its bailout fund, theEuropean Financial Stability Facility, with the Spanishgovernment apparently still on the hook.

The ECB persists in the fiction that it can’t lend togovernments for deficit financing, but it really is. Andincreasingly, European leaders view the ECB as the onlyinstitution with the unlimited resources to keep the bailout


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money flowing. The bank’s President,Mario Draghi, more recently said theECB, within its mandate. “is willing todo whatever it takes to preserve theeuro and, believe me, it will be enough.”Then on September 16, the ECBannounced that it would buy sovereigndebts of troubled eurozone countries,up to three years’ maturity, in an“unlimited” program, as mentionedearlier, as long as they met austeritytargets—the Outright MonetaryTransactions Program (OMTP). Don’tyou wonder who dreams up the namesfor the never-ending list of bailoutprograms with interesting acronyms?Think, in the U.S. alone, we have TARP,TALF, ARRA, CARS, HARP andHAMP, among others. The ECB hasEFSM, EFSF and ESM. The Bank of England has APFand FLS. Do you even know what these acronyms standfor?

ECB Limits

But just as there are limits on the Fed’s QE3 even thoughit’s supposed to be open-ended, there are also limits on theECB’s open-ended policies, even though it can theoreticallyexpand its assets forever. The credibility of the ECB isultimately backed by the German balance sheet. So far,investors have put German government bund in the samesafe haven category as Treasurys (Chart 51), in sharpcontrast to their disdain for Spanish and Italian debt amidstnonstop credit warnings and downgrades.

But that faith may be wearing thin. Moody’s recently evencut the outlook for stalwart Germany, the Netherlands andLuxembourg from stable to negative. The rating agencycited the risk of Greece leaving the eurozone and the costsof containing the subsequent contagion. In its recentannouncement, Moody’s said that Germany had reachedthe limit of its ability to carry the financial costs of bailouts,even with its likely 2012 government deficit equal to only0.8% of GDP. Germany so far has committed €211 billionin cash and guarantees to eurozone rescue funds. It citedGerman bank exposure to weak countries, high Dutchhousehold debt and Luxembourg’s very high dependenceon the financial services industry. According to the IMF,German lenders have the highest exposure in Europe toSpain, $140 billion, of which $46 billion is exposure tobanks.

On The Ground

Back on the real eurozone economic ground, the situation

CHART 51U.S. and German 10-Year Government Bond Yields


Last Points 10/3/12: U.S. 1.63%; Germany 1.46%

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Nov-10 Aug-11 May-121.0

1.5

2.0

2.5

3.0

3.5

4.0

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1.0

1.5

2.0

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4.0

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5.0

5.5

U.S.

Germany

is dire. The eurozone financial crisis has spilled over to thereal economy and will probably result in a recession as deepas the 2008-2009 slump. Back then, eurozone real GDPfell 5.7%, more than the 4.7% swoon in the U.S. (Chart 52).Nevertheless, while American real GDP is now slightlyabove the fourth quarter 2007 peak, eurozone growth wasflat in the first quarter before the previous peak wasreached and fell 0.7% in the second quarter at annual rates.

Evidence of the deepening eurozone recession is legion.The unemployment rate for the 17-country bloc continuesits steep ascen. In August, the unemployed rose 34,000 to18.2 million and in the larger EU, 25 million are jobless. InGreece, 55% of those younger than 25 are unemployed,53% in Spain, 32% in Ireland but only 8% in Germany. Aseurozone unemployment rises, consumer confidence andspending, naturally, fall. Consumer confidence was at a 40-month low in Europe in September. Sales volume fell 0.2%in July from June and was off 1.7% from a year earlier.

Manufacturing activity is falling in the total eurozone andeven in France and Germany (Chart 53). So even export-led Germany is succumbing to the downdraft.

Japan

Japan is no stranger to quantitative easing and has beenusing it for two decades, as well as using massive governmentdeficits and debt, to try to escape her two-decade-longdeflationary depression. The Bank of Japan recentlyincreased its asset purchase program to ¥80 trillion ($1trillion) from ¥70 trillion and extended the program by sixmonths until the end of 2013.

Nevertheless, the recovery from the March 2011 earthquakeand tsunami appears to be waning. Real GDP growth


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swung violently from negative as aresult of that disaster to big recoverygains, but now has settled back to lowgains with only a 0.7% rise in the secondquarter from the first quarter at annualrates, revised down from the 1.4%earlier estimate. Industrial productionfell 1.3% in August from a monthearlier after a 1% drop in July. Inexport-driven Japan, exports dropped7.4% in July from a year earlier, thesecond straight monthly fall, due toweak demand from Europe and China.Consumer prices continue to fall.

China

As noted at the outset of this report,China is using a different strategy thanWestern lands and Japan in respondingto chronic economic weakness. Chinabasically used bank lending, theequivalent of 12% of GDP in 2008-2009, to revive her economy from theGreat Recession. Real GDP growthyear-over-year had fallen to 6% in early2009 (Chart 54), well below the 8% rateneeded to accommodate new jobentrants. In contrast, the U.S. 2009fiscal stimulus was half as big—6%—inrelation to the economy.

Much of the money in China went forexcess capacity-creating capitalspending, real estate speculation anddevelopment loans arranged by localgovernments. They legally can’t borrow,but after essentially stealing land fromlocal farmers, they arranged for loansthrough off-balance sheet vehicles toproperty developers and they profitedby taxing the structures they built.

The economy revived quickly but aproperty bubble and high inflation wereundesired consequences, especiallyleaping food prices in an economy withmany people at subsistence incomelevels. So China reversed gears to slowher exuberant economy, and thoseefforts have born fruit, probably toomuch for Chinese leaders’ tastes.

House prices cracked due to tightcontrols on mortgages and speculative

CHART 52U.S. and Eurozone Real GDP Since 2007-2009 Recession Peak

Source: eurostat and Bureau of Economic Analysis

Last Points 2Q 2012: EZ 97.6; U.S. 101.7peak quarter = 100

2007Q4 2008Q4 2009Q4 2010Q4 2011Q494

95

96

97

98

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102

94

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96

97

98

99

100

101

102

Eurozone (Q1 2008 Peak)

US (Q4 2007 Peak)

CHART 53German, French and Eurozone Manufacturing PMI

Source: Markit

Last Points 9/12: Germany 47.4; France 42.7; eurozone 46.1


35

40

45

50

55

60

65

30

35

40

45

50

55

60

65

Germany

France

Eurozone

CHART 54Chinese GDP

Source: Chinese National Bureau of Statistics

Last Point 2Q 2012: 7.6%year/year % change

2005 2006 2007 2008 2009 2010 2011 20125%

6%

7%

8%

9%

10%

11%

12%

5%

6%

7%

8%

9%

10%

11%

12%


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homeownership. Stock markets areusually excellent harbingers of economicactivity, and the Shanghai CompositeIndex, which partially revived in 2009after its 2007-2008 collapse, has beentrending down ever since. This slideprobably foretells a hard landing inChina, with 5% to 6% real GDP growthrates, well below the 7.5% governmenttarget, down from the 8% target foreach of the previous eight years.

Reserve Requirements

The Chinese central bank relies onadjusting reserve requirements toimplement monetary policy. FromJanuary 2010 to late November 2011,it raised reserve requirements 12 timesfrom 15.5% to 21.5% (Chart 55). Incontrast, it only hiked lending rates fivetimes to 6.56% from 5.31% in order tosubsidize, with low-interest costs, theinefficient state enterprise borrowersthat are crucial to the economy. Theyemploy about a quarter of the workforceand account for 50% of GNP. Notethat the Fed hasn’t changed reserverequirements in decades and considersthem crude, sledgehammer tactics.Reserve requirements limit bank lendingsince they amount to credit rationing,while higher interest rates stil laccommodate the most promisinginvestments.

China’s primary dependence on exportsfor growth is also causing problems as aglobal slowdown unfolds and worldwide recession looms.Hopes of economic decoupling of China and other Asianlands from the U.S. and Europe have once again surfacedin recent years. And once again, they are being dashed. Asshown in Chart 56, almost 20% of Chinese exports wentto the EU in 2011, and deepening recessions there havereduced them to 5% this year through August. Chineseexports to the U.S. were close behind those to the EU in2011 at 17% of the total, and the drop in European-boundChinese exports has put the U.S. in first place this year.Exports to America were still rising in the second quarter,up 14.4% from a year earlier. Overall Chinese exports arebarely growing and well below the earlier 20% to 30%norm.

The earlier economic restraints and slipping exports aredepressing Chinese economic activity. Industrial production

growth fell to 8.9% in August from a year earlier, downfrom the earlier 15% or higher growth rates. The lowerGDP growth in the second quarter versus a year earlier,7.6% due to waning exports and weak real estate, mayvastly overstate reality, and official Chinese numbers ingeneral are highly suspect. The HSBC China ManufacturingPurchasing Managers Index has been below 50, indicatingactual contraction, for 15 of the last 16 months. Directforeign investment in China is declining.

Industrial company profits dropped 6.2% in August for thefifth month, and the drop accelerated from the 5.4%decline in July and 1.7% in June. Selling prices are falling,demand is slowing and costs are rising with the 20%-25%recent hikes in minimum wages. In the first eight monthsof 2012, profits slid 2.7% compared with a 28.2% gain ayear earlier. Revenues rose 10.2% in the first eight months

CHART 55Chinese Reserve Ratio and One-Year Lending Rates

Source: Bloomberg

Last Points 10/3/12: reserves 20.0%; loans 6.00%

Jan-07 May-08 Sep-09 Feb-11 Jun-124%

6%

8%

10%

12%

14%

16%

18%

20%

22%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

Required Reserve Ratio (major banks) - left axis

One Year Lending Rate - right axis

CHART 562011 China Trade by Partner

Exports($ bil.)

Exports(% of Total)

Imports($ bil.)

TotalEU (27 countries)U.S.Hong KongEurozone*ASEANJapanKoreaIndiaTaiwan

1743.5211.2122.2

15.5141.7192.8194.6162.7

23.4124.9

100.0%18.8%17.1%14.1%14.8%

9.0%7.8%4.6%2.7%1.8%

100.0%12.1%

7.0%0.9%

10.2%11.1%11.2%

9.3%1.3%7.2%

Imports(% of Total)

1898.6356.0324.5268.0233.0170.1148.3

87.950.535.1

* 2010 data Source: China Customs


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vs. 29.9% in the comparable 2011 period.

Avoid Social Unrest

Chinese leaders want to avoid a hard landing and the highunemployment and social unrest of the sort that spawnedthe Tiananmen Square uprising in 1989. High unemploymenthas gotten numerous Chinese dynasties tossed out, and theleaders of the Mao Dynasty, as we’ve dubbed it, know theirhistory. Beijing eased bank lending limits and reserverequirements for smaller banks back in September to helpstruggling small businesses and offset the stringent restraintson shadow lending. And starting Nov. 30, China’s centralbank reduced the bank reserve requirements three times,back to 20.5%. The once-in-a-decade change in Chineseleadership later this year is also adding stress to policydecisions.

We have no doubt that Chinese leaders will act decisivelyenough to prevent a prolonged hard landing. But we doubtthat Chinese leaders will act quickly enough and be cleverenough to prevent a drop in growth to the 5% to 6% rangefor at least several quarters.

The technique they used in 2008-2009—funneling massiveloans through the banks for infrastructure and other capitalprojects—will probably not work a second time, even withfurther substantial reductions in reserve requirements.Also, Chinese banks are reluctant to lend for industrialcapacity additions when it is already more than ample as aresult of the last lending spree and mounting loan losses.Bank liquidity is ample and weakening loan demand bybusiness suggests subdued investment demand. Withattractive infrastructure investments already made,additional ones will take time to develop. Many firms lackprofitable investment opportunities.

Monetary and Fiscal Stimuli

With this reality, it’s not surprising that on June 7, China’scentral bank cut the one-year yuan lending rate to 6.31%from 6.56% and to 6.00% on July 6 while allowing banksto offer loans up to 30% below the benchmark rate. Withthe two rate cuts and the allowed discount, the cost of a one-year loan fell more than two percentage points, from 6.56%to 4.2%, in a month.

It also appears that the authorities want to go around thereluctant banks and appeal to borrowers directly by makingmoney available at rates low enough to encourage profitableinvestments. The average return on capital investmentshas fallen from 11.6% in 2007 to 6.7% last year, barelyabove the earlier one-year lending rate of 6.6%. We takethis as concrete evidence of Chinese leaders’ concerns overa faltering economy. So did Chinese investors as the

Shanghai Stock index dropped 2.7% over the next twotrading sessions after the last rate cut.

Chinese leaders appear to believe that further monetaryease will not rekindle economic growth and may spawnanother real estate bubble. So they’re turning to fiscalmeasures. The national Development and ReformCommission, a powerful government planning agency,approved 1,555 major investment projects this year throughAugust, a 13% rise from 2011. And, as noted at the outset,in early September, the Chinese government announced$158 billion more in infrastructure projects over four years.

Nevertheless, the fact that this amount is only 26% of the$586 billion stimuli in 2008-2009 enacted over two yearssuggests that the government is wary of overdoing it withundesired consequences, as occurred earlier with the propertybubble and inflation. Also, Chinese leaders may be reflectingthe reality that “more of the same” in exporting industriesand the capital spending that supports them no longerworks and only creates troublesome excess capacity as thebig importers, the U.S. and Europe, retrench.

As discussed in past Insights, they recognize that they needto boost consumer spending and a domestically-orientedeconomy to ensure future meaningful growth in China. Arecent shift of government emphasis away from supportingexport growth and towards domestic needs in South Korea,Thailand, Malaysia and elsewhere indicates that this policyshift is widespread.

China And Commodities

Despite the initial pop in the prices of commodities such ascopper in reaction to monetary and fiscal stimuli in the U.S.,Europe, Japan and China, they remain in a downtrend thatcommenced in early 2011. And we expect commodityprices to continue to drop as the hard landing in China andglobal recession unfold. The Dow Jones-UBS CommodityIndex jumped 15% since the Fed hinted at QE3 on June 6,but is down 1% since QE3 was announced on September13. Buy the rumor, sell the news?

As we’ve noted in past Insights, it’s probably no coincidencethat China’s joining the World Trade Organization at theend of 2001 was followed by the commencement of theglobal commodity price bubble in early 2002. And it hasbeen a bubble, in our judgment, based on the convictionthat China would continue to absorb huge shares of theworld’s industrial and agricultural commodities. The shiftof global manufacturing toward China magnified hercommodity usage as, for example, iron ore that previouslywas processed into steel in the U.S. or Europe was sent toChina instead.


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As a result, China in recent years consumes 42% of annualworld production of nonferrous metals such as copper, tin,lead and zinc as well as half of global iron ore output andhuge portions of coal and other industrial material. China’soil stockpiles are unknown but probably have leaped. She’salso importing soybeans, grains and other agriculturalproduction heavily as diets are upgraded to contain moremeat. Chickens and hogs don’t convert all of the corn theyeat to meat, so more grain is needed than if it’s eaten directlyby humans.

Agricultural producers are influenced by global demandbut also by weather-driven supply. Forecasting economiesis tough enough, so we’ll leave it to others to forecast theweather. Note, however, that in the past, ideal growingweather often follows the bad weather suffered lately, andbumper crops and barn-bursting surpluses often replacehand-wringing shortages in a crop year or two.

Evidence of the commodity bubble is rampant. Individualinvestors are participating through ownership of miningcompany stocks and Exchange-Traded Funds, some ofwhich own physical commodities. Commodity-orientedmutual funds and ETFs had $50.7 billion in assets at the endof 2011, up from $258 million in 2002. Pension funds andother institutional investors are also aboard, owning physicalcommodities or substitutes. Many now regard commoditiesas an asset class like equities and bonds, which we doubt, asmentioned earlier. Excess copper is piling up in and outsideShanghai warehouses, as mentioned at the outset. Witheasy access to money from government-controlled banks,state-owned Chinese steelmakers have kept producingeven though manufacturing activity has declined for overa year. The result is 16 million tons of surplus steel alloy,15% more than a year ago. This is only adding to a globalglut of steel.

Reversing Gears

With more and more agreeing with our long-held belief thatChina is in for a hard landing, withdrawing from commodity-oriented funds has commenced. In the first seven monthsof this year, investors yanked $6 billion from commoditymutual funds compared with a $7.8 billion inflow a yearearlier. A survey in August found only 2% of investorsinterested in China-focused commodity funds that typicallyinvest in big Chinese imports such as iron ore, soybeans andrubber. At the beginning of the year, 15.4% were favorablydisposed.

The end of the commodity bubble is not only negative forcommodity prices but also commodity-exporting countriessuch as Brazil and their currencies as well as suppliers tocommodity producers. Australia has, in many ways,become a Chinese colony as they dig up the island continent

and export the iron ore, copper, coal, etc. to China. TheAustralian government planned to erase a $46 billionbudget deficit with higher taxes on mineral producers. Butwith iron ore prices down 24% in August alone, they areabout half the level the Australian government planned on.Coal prices are half their 2008 peak. So miners areretrenching and canceling expansion projects, leavingAustralia with a potential $10 billion shortfall in tax receipts.

Then on October 3, the Australian central bank cut itstarget rate by 0.25 percentage points to 3.75%, with acumulative 1.50 percentage point decline since lastNovember. In announcing the cut, Reserve Bank ofAustralia Governor Glen Stevens said, “Growth in Chinahas also slowed, and uncertainty about near-term prospectsis greater than it was some months ago. Key commodityprices for Australia remain significantly lower than earlierthis year.”

This reverses his view last June when he said he needed todo some “cheerleading” on the economy to rebut vocalpessimists. But the Australian economy has slippedmeanwhile. Iron ore prices have collapsed, and miners areslashing investments, as mentioned earlier. Australianexports to China equal 5% of GDP, and 60% are shipmentsof ore. Australian growth slipped to 0.6% in the secondquarter from 1.4% in the first, payrolls were unexpectedlycut in August and business confidence is falling. The tradedeficit leaped in August and the Australian dollar is falling.

In the U.S., Appalachian metallurgical coal prices hit arecord $330 per metric ton in early 2011 as Chinesedemand soared. But with Chinese imports faltering alongwith manufacturing activity there, prices are down almost50% to $170 per metric ton. This and the shift of U.S.electric utilities to cheap, cleaner natural gas is causingproduction cutbacks, mine closings and layoffs in the U.S.coal industry.

Not surprisingly, miners worldwide are cutting capitalspending due to production cuts, weak prices and fallingprofits. Caterpillar recently lowered its profits forecast forthe next few years due to weak demand for constructionand mining equipment.

Global Weakness

We’ve concentrated in this report on unfolding economicweakness in Europe, the U.S. and China and those threeareas, which account for 57% of global GDP, do take therest of the world with them—up and down. And there’sgrowing evidence that’s happening on the downside.

Purchasing managers indices show that manufacturingcontinues to fall in Vietnam and Taiwan, and growth is


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slowing in Indonesia. Declines reign in South Korea,Australia, Taiwan and Brazil. Consumers globally arecutting back on the ubiquitous hamburger. In July,McDonald’s same-store U.S. sales fell 0.1% and declined0.6% in Europe and 1.5% in the faster-growing economiesin Asia/Pacific, Middle East and Africa.

International trade is more volatile than overall economies,in part because it largely involves goods that are morecyclical than services. And trade is definitely slowing.Global air freight volume in July fell 3.2% from a yearearlier. FedEx CEO Fred Smith points to economicweakness in Europe and the U.S. as well as in China. BothFedEx and UPS have cut their flights to the U.S. fromChina, in part due to competition from cheaper oceanshipping. There’s less need for fast delivery when sales areslack.

But ocean shipping is also falling. In the ports of LongBeach and los Angeles, which handle most of the U.S. oceantrade with Asia, outbound container shipments fell 4.1% inAugust from a year earlier, the sharpest drop since September2009. AP Moller-Maersk, the giant Danish shipper thataccounts for 15% of global seaborne freight, has cutcapacity on Asia-Europe routes by 9% and is reducing shipspeeds to save fuel costs. Asia-Europe ocean freight ratesfell 30% in the August-September period.

The World Trade Organization forecasts world trade ingoods to rise just 2.5% this year, down from 5% growth in2011 and 14% in 2010. And that forecast is probablyoptimistic in view of weakening global economies. U.S.export growth has accounted for about half of GDP gainsin this recovery vs. 12% of growth in the last four decades.The Administration’s goal of doubling exports in the fiveyears after the recession ended in June 2009 is obviouslysuspect.

Shocks

The Great Disconnect we’ve discussed in this reportbetween investors enamored with monetary and fiscallargesse and globally weakening economies is profoundlyunhealthy. And in our opinion, the gulf will be closed,sooner or later, one way or another. Of course, it could beeliminated by rapid expansion of economies globally. Thepast and current massive monetary and fiscal stimuli orother forces might rekindle economic growth. Some pointto the recent stabilization of U.S. house prices as thebeginning of this economic revival.

We doubt it, however. The massive deleveraging in privatesectors here and abroad, the unresolved odd couplecombination of the Teutonic North and the Club MedSouth in the eurozone and the needed shift in China from

an export-led to a domestically-driven economy suggestthat “risk on” investments will collapse to meet recessionaryand chronically slow growing economies.

What will cause the agonizing reappraisal by bullish investors?Probably a shock, as was the case in limited ways with theeuphoria over QE1, QE2 and Operation Twist. The firstGreek debt crisis in early 2010 ended the QE1 stock rally.The QE2-spawned bull ended with Greece II and thewidening European financial and economic woes in early2011. Operation Twist optimism concluded with therealization that European problems may be unsolvable andwith worries over the fiscal cliff in the U.S.

The current gap between sliding global economies andstock market euphoria remind us of Wile E. Coyote in the“Roadrunner” cartoons who runs off the cliff and standson thin air until he finally realizes there’s nothing betweenhim and the valley floor below. A sizable shock mayprovide investors with that realization. Forecasting specificjolts is hazardous, although we can list several possibilities.

A hard landing in China might do the job, with growthslowing to 5% to 6%, especially as the dire ramifications onworld trade, commodities demand and prices andcommodity producers and their currencies roll out.Increasing numbers are agreeing with us that this is in thecards, and maybe that's behind the recent possible shiftfrom "risk on" positions to "risk off" trades—the quartetof long Treasury bonds, short stocks, long the U.S. dollarand short commodities.

A fall off the fiscal cliff is another possibility. It’s wellknown that if Congress and the Administration don’t act, atthe end of this year, the Bush-era tax cuts disappear, thepayroll tax on employees goes back to 6.2% from 4.2%,unemployment benefits drop from a 99-week maximum to26 and the first of $1.2 trillion in federal spending cuts andtax increases over 10 years commences (i.e., "sequestering"),the result of Washington’s failure to deal with the longer-run budget deficit last year. The nonpartisan CongressionalBudget office estimates that the fiscal cliff will slash 2013GDP by 4.0% (Chart 57). That in itself constitutes a majorrecession, even more so coming on top of an alreadyrecessionary economy.

We’ve been assuming that Washington will avoid, or as theydid in the summer of 2011, at least temporarily postponethe fiscal cliff—even before the election in employmentcontinues to deteriorate. Even the tea party Representativesand Senators want to get re-elected, and telling constituentsthat austerity is good for their souls doesn’t garner manyvotes. Alternatively, with gridlock in Washington, Congressand the Administration in a lame duck session after theelection could postpone the tax increases and spending cuts


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temporarily to let the next Congressand Administration deal with the mess.That's what they did last Decemberfor three months and then in Februaryfor the rest of this year.

One way or the other, we doubtseriously that Washington will allowthe economy to go off the fiscal cliff.Our old friend, the late Barber Conable,earlier the ranking Republican on theHouse Ways and Means Committeeand later President of the World Bank,told us repeatedly, “Congress ultimatelydoes the necessary thing, but onlywhen forced to and as late as possible.”Few in Washington are likely to standon principle and let the economy fallinto an abyss.

We doubt that many Americanbusinesspeople and consumers believe the fiscal cliff won’tbe removed, even though many cite the risks as a rationalefor the general uncertainty that is retarding spending andcapital investment. Note, however, that removing the fiscalcliff does not add new stimuli to the economy. It simplykeeps existing government spending and tax rates intact.

An oil price leap, triggered by an Iran-related blow-up in theMiddle East, could also shatter investor euphoria. That’swhat happened with the Arab oil embargo in 1973 and theIranian revolution in 1979. Sure, the U.S. is becoming lessdependent on imported energy and very few oil importscome from the Middle East. But petroleum is fungible andprice increases elsewhere will affect the U.S.—as well asEurope and China. A huge energy cost spike would be adebilitating tax on already-stressed consumers.

Failure of a major European bank would probably spreadworldwide and generate a global financial crisis, much as in2008. Banks are so intertwined through loans, leases,derivatives, etc., as noted earlier, that a shot in Europewould be felt ‘round the world.

Major corporate earnings disappoints are another possibleshock. Always-optimistic Wall Street analysts believe S&P500 operating earnings fell slightly year-over-year in thethird quarter but that’s well known and a 14% year-over-year revival in the fourth quarter is expected. But supposeour forecast is correct and operating earnings drop to $80per share in a coming four-quarter stretch, due to recession-induced declines in corporate revenues, a decline in profit

margins from record heights and currency translationlosses as the dollar strengthens? That $80 is more than 20%lower than analysts’ estimates, and would be a bigdisappointment to many bullish investors.

Investor Caution

QE1, QE2 and Operation Twist got increasingly largerbangs per Fed buck. But not so with QE3 and recent ECBactions, at least so far. As noted earlier, each successiveannouncement by the Fed and ECB got less pop in the S&P500. Since peaking on September 14, the day after the QE3proclamation, that index has declined on balance, in contrastto gains in comparable days of trading after the three earlierquantitative easings. Treasurys have rallied vs. little changeafter earlier QEs.

It's early into QE3, but does this suggest that investors aregetting cautious and wary, that the Fed has gone back to thewell one time too often? Are investors anticipating a hardlanding in China or one of the other shocks we just outlined?Stay tuned.

It should be clear from this report that we beg to differ withthe “It’s so bad, it’s good” crowd. Conditions are so bad,they’re just plain bad. All the immense monetary and fiscalstimuli here and abroad in the last five years have failed tooffset the gigantic deleveraging in global private sectors.And they’re unlikely to do so until that process is completedin another five to seven years.

CHART 572013 Effects Of Fiscal Cliff

$ bil. % of GDPTax Increases Expiration of Income Tax Cuts 2001-2012 Expiration of Payroll Tax Cuts Expiration of Other Tax Provisions Payroll Tax Increases (Affordable Care Act)Total Tax Increases

Spending Cuts Sequestration - Budget Control Act Expiration of Emergency Unemployment Benefits Reductions in Medicare Physician Payment RatesTotal Spending Cuts Other Revenues/Spending

Total Fiscal Adjustment

1.5%0.6%0.4%0.1%2.6%

0.4%0.2%0.1%0.7%0.7%

4.0%

$221$95$65$18

$399

$65$26$11

$102$106

$607Source: Congressional Budget Office

Change (yr/yr)


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If you enjoy reading Gary Shilling's monthly "Commentary," you may be interested in Letting Off Steam, a collection of more than 130 ofGary's "Commentaries" from 1989 through 2003. This 286-page book is available for $20 (shipping included). Call 973-467-0070 to order.

Commentary

How To SlashHospital Waiting TimeMy wife has suffered a sore rightknee for some time that was diagnosedas a tear in the meniscus, the cartilagethat acts as a shock absorber betweenthe thigh bone, or femur, and the shinbone, or tibia. A local orthopedicsurgeon recommended a kneearthroscopy, a fairly commonprocedure that takes about 20 minutesunder general anesthesia.

The surgeon makes a small cut, fillsthe knee area with saline to expandthe space and inserts a scope aboutthe size of a pencil with a light and tinyvideo camera to look around.Through another cut, he inserts tinyscissors to trim off the torn edge ofthe meniscus. Then he withdraws theequipment, the saline is drained, theknee is bandaged and the patient isoff to the recovery room.

My wife’s appointment forarthroscopy as a day patient at a localhospital was for 11:00 a.m., but thenight before, they changed it to noon.That should have warned us of a longwait. Still, we arrived early, and aftera half hour stay in the general receptionarea, were sent to the surgery sectionfor another 15-minute delay beforebeing called to check in. They tookmy wife in, dressed her in a hospitalgown on a gurney and hooked her upto a saline IV before I rejoined her.By now, it’s about 12:30 p.m., andwe’re told the surgery is scheduledfor 1:00 p.m.

But 1:00 comes and goes. Finally, agregarious male nurse arrives to besure my wife is the right patient forthe planned procedure—confirmingher name; birth date; regular

medications she takes; no food, drinkor medications since last midnight;which knee is to be operated on, etc.His and numerous checks by othersas well as the various pre-operationtests made it clear that a tremendousamount of the staff’s time and expenseis devoted to defensive medicine—avoiding simple mistakes that couldresult in lawsuits.

We asked about the long delay and heexplained that the surgeon was movingback and forth between two operatingrooms, but the scheduling for eachwas handled and fully booked by aseparate computer. So the double-booked surgeon was positively,absolutely guaranteed to run behind.Can’t a real live human being simplyoverride the two computers that don’ttalk to each other, we asked. No, theyoperate separately within the system,he told us.

This was scary for my wife and me. Ifsuch an obvious problem was beyondhuman control, what about hiddenbut more critical aspects of thehospital’s medical care? We werepartially relieved when another malenurse appeared with a magic marker,confirmed with my wife that her rightknee was the troubled one and drewa wide circle around it with “yes”written inside. Low tech but effective.

I suspect, however, that theoverbooking problem was not pooradministration of computers, but thezeal of the surgeon, who did about adozen knee operations a day, to notwaste a second in maximizing hisoperating time and income. Clearly,our waiting time was valued at zero.

These long delays were obviouslyenhancing our pre-op anxiety, butthey finally wheeled my wife into theoperating room after 3:00 p.m. I wastold that she’d be out of the recovery

room in an hour and got worriedwhen I’d heard nothing by 5:00. So Idemanded action and was allowed torejoin her in the recovery room. Thesurgeon also finally responded to mycall and told us that all went well witha simple trimming of the meniscus.After verbal and written instructionsfrom him and the nurses, and a furtherstay in the secondary recovery room,we finally left for home at 6:30.

The staff were friendly but said theyhad no control over the long delays.Nevertheless, should we as patientsroutinely accept waits that totaledfive hours? I have a simple three-stepplan that will instantly eliminateunnecessary patient heel-cooling timeand do so by using the marketmechanism, not more regulation.

First, remove half the chairs in waitingrooms. Burn them, trash them, giventhem to charities. They’re gone. Thenirritated and standing patients willdemand prompt service.

Second, take all TV sets out of waitingrooms so patients will have nodistractions from the boredom oftheir long waits and will be furtherirritated.

Third, charge each physician $1,000for each and every one of his patientswho stands for lack of a chair.

The result of these three simple stepswill no doubt be much greater demandby patients for quick service and aleap in the supply of on-timeperformance by medical practitioners.Does my plan sound ridiculous? Inan era of intense experimentation todeal with exploding medical costs anda very inefficient delivery system, it’sworth a try.

insight 1012b

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