volume 2.13 increasing risks aug 27 2010

8/9/2019 Volume 2.13 Increasing Risks Aug 27 2010

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BOECKHINVESTMENTSINC.,17501002SHERBROOKESTREETWEST,MONTREAL,QUEBEC.H3A3L6TEL.5149040551,[email protected]

VOLUME 2.13AUGUST 27,2010

IncreasingRisksThe artificial nature of the U.S. economic recovery from the recession lows has

always been obvious. In recent months, judging from media coverage, it is now

mainstream. While there are a few lingering signs that support some modest optimism,

it is getting difficult to find much to cheer about. In our letter Vol. 2.10, The Artificial

Economic Recovery, dated July 23, 2010 we pointed out that the U.S. growth trajectory

was converging on 1% p.a. With revisions to second quarter GDP that seems to be fact

now. A double-dip U.S. recession is still not a done deal but forces are all on the side of

economic weakness and deflation, and a double-dip recession next year carries a

significant possibility.1

Charts 1-3 show how the weak recovery in employment and production

prospects and the stability in housing have all gone into reverse in spite of zero interest

rates. This is highly unusual, to say the least, after only five quarters of economic

recovery. The message is clear: the policy stimulus provided only a short-term boost.

1SeeBrianReading,ContributingEditor,BoeckhInvestmentLetter,Vol.2.11,August2,2010, RollerCoasterEconomics:PreparefortheNextDownturn. Inthepagesbelow,weelaborateonsomeofthethemesheraisedaswellassomeothers.


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BOECKHINVESTMENTLETTER WWW.BOECKHINVESTMENTLETTER.COM 2

CHART 1 CHART 2

CHART 3

It is clear that there is one global market place for goods, services and money.

And the world has become, once again, structurally very unbalanced and hence, fragile,

as pointed out in our Letter dated August 2, 2010, Volume 2.11, Roller Coaster

Source: Thomson Reuters Datastream

PHILADELPHIA FED DIFFUSION INDEX MFGLatest: 15/08/2010

2005 2010-40

-30

-20

-10

0

10

20

30

40

-40

-30

-20

-10

0

10

20

30

40


EXISTING HOME SALESLatest: 15/07/2010 (Thousand)

2005 20103000

3500

4000

4500

5000

5500

6000

6500

3000

3500

4000

4500

5000

5500

6000

6500


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Economics: Prepare for the Next Downturn, and discussed at length in The Great

Reflation.2

For many years prior to 2008, there was a precarious disequilibrium requiring a

delicate balancing act to keep things afloat. The crash demolished this artificial world

and created another one via the greatest peacetime global reflation in history. In the

vernacular, we describe this as trying to pump air back into the burst balloon.

Many would argue that the structural disequilibrium, directly and indirectly, was a

principle cause of the crash. We are now heading back in that same directiongrowing

surpluses in China, Germany and Japan (Charts 4-6) and the counterpart, growing

deficits in the U.S. and other weak debtor and deficit nations. This is a recipe for

disaster because the deficit countries do not have the internal and external balance

sheets to absorb the excess savings in the rest of the world. Rather than leveraging up

their balance sheets, as they once did to consume, they are deleveraging under the

pressure of markets to get liquid. When everyone tries to get liquid, either by saving

more and spending less, or by trying to get others to buy their goods (in order to get

their liquidity), the result inevitably is that liquidity shrinks in the key areas where it is

most needed.

2J.AnthonyBoeckh,TheGreatReflation(Hoboken,NJ: JohnWiley&Sons,April2010)


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CHART 4 CHART 5

CHART 6 CHART 7

In the U.S., deleveraging in the household sector (Chart 7) has barely begun in

spite of a surge in the savings rate, yet the U.S. trade deficit has widened dramatically

(Chart 8). The counterpart is an explosive growth in exports of surplus countries like

China, Germany and Japan. Chart 9 shows Chinas surging trade balance.


CHINA: EXPORTSLatest: 15/07/2010 (USD Billions S.A.)

2005 20100

20

40

60

80

100

120

140

0

20

40

60

80

100

120

140


GERMANY: EXPORTSLatest: 15/06/2010 (EURO Billions S.A.)

2005 20104

5

6

7

8

9

4

5

6

7

8

9


U.S. PRIVATE SECTOR DEBT TO GDP RATIO31/03/2010

1950 1960 1970 1980 1990 2000 20100.0

0.2

0.4

0.6

0.8

1.0

1.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2


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CHART 8 CHART 9

The most egregious offender is mercantilist China Inc., with its enormously

undervalued exchange rate, loan subsidies to exporters and a variety of other import

restricting / export subsidizing policies. Its dramatic foreign exchange reserve growth in

recent years reflects these policies. The resulting addition to Chinese liquidity feeds

real estate bubbles (but not yet the stock market in this cycle). China does try to

sterilize the monetary effects of reserve accumulation but it is not easy to do on a

sustainable basis.

Effectively, the surplus countries are stealing growth from the deficit countries

and not allowing them to adjust to external and internal disequilibrium. In the U.S., this

can be seen most clearly by the simultaneous rise in the savings rate, the trade deficit

and the deterioration in labor market data. When the natural forces of the adjustment


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process to economic disequilibrium are blocked, political tension must necessarily

increase. In an election year, you can expect vulnerable politicians to act.

The options in this situation for a country like the U.S. are limited and not very

good. Apart from further pushing on the monetary string (alias quantitative easing,

formerly known as money printing), there is the possibility of more fiscal stimulus. With

the U.S. government debt:GDP ratio already heading toward 100 by the end of the

decade, this is a dangerous option and unlikely to buy much growth, nor for very long.

However, politicians in the U.S. have never been known to worry too much about the

longer run.

The third option is for the U.S. to opt for non-market solutionstit-for-tat

mercantilismto boost domestic demand and employment at the expense of foreigners.

Trade protection can be employed via competitive devaluation, tariffs, non-tariff trade

restrictions, etc. It was last tried in the 1930s when surplus countries didnt allow deficit

countries to adjust. It would be a far more dangerous option now because the U.S. is a

large foreign debtor. The U.S. has net liabilities of over $3.5 trillion, most of which are

held in short-term instruments by central banks who could try to dump them in

retaliation. The international monetary system is seriously flawed as it was in the

1930s, although there is the important difference that domestic money supplies are not

rigidly linked to central bank holdings of gold or foreign exchange assets. Nonetheless,

great instability with the major reserve asset of the worlddollarswould be

catastrophic.


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The options for other debtor countries are far more limited than for the U.S.

Deficit countries in the euro area are currently being forced into fiscal austerity. More

government spending and tax cuts are not going to happen. Nor do these countries

have a monetary/competitive devaluation weapon in their tool box. By default, that

leaves deflation, declining incomes and high unemployment (20% in Spain with Greece

heading there) as the logical outcome. When social tensions reach the breaking point,

trade protection will be seen as an alternative. In more extreme circumstances, some

countries might depart from the euro, create their own currency and massively devalue.

The result would be high inflation and chaos.

Apart from the U.S. and countries in the euro area, there are a variety of others

with finances and economies in various states of disarray. The U.K., one of the larger

ones, has gambled on major fiscal deflation. Even with major cutbacks, some

forecasters such as Moodys see U.K. debt spiraling up to 90% of GDP in three years.

Japan, after 20 years of stagnation, has a government debt:GDP ratio over 200%. How

Japan has managed to avoid a sovereign debt crisis for so long is a mystery, only partly

explained by its formerly high personal savings rate. This has been falling in recent

years, although a surge in corporate savings has kept total savings at the national level

very high. With dismal growth prospects and rapidly deteriorating demographics, the

overvalued yen is an accident waiting to happen (Chart 10). Most of Eastern Europe is

also in dire straits, propped up with IMF credits. The few bright spots tend to be

commodity producers such as Canada, Australia, Norway and Russia. Nevertheless,


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they will have trouble hiding if the world goes protectionist, anti-market and growth

suffers.

CHART 10

These prospects should not be seen as a forecast yet. But the growing tensions

from the deteriorating world economy, the need for sustained, large public and private

deleveraging and the imperative of resolving global disequilibrium must be credibly

addressed without delay. Time is of the essence. The global slowdown is accelerating

and the U.S. faces a key election in 10 weeks. Failure to deal with these issues will

inevitably push the U.S. and other debtor countries into taking action against the surplus

countries to steal back growth. Everyone knows that would be a disaster, but it doesnt

mean it wont happen. When options run out, you do what you have to, and that

includes politicians facing voters who are looking for quick and easy solutions.

The key for investors is to understand that adjustments will happen. The process

of trying to get a positive resolution will be messy, fraught with belligerent threats on all


JAPANESE YEN EFFECTIVE EXCHANGE RATE15/07/2010

2005 2010110

120

130

140

150

160

170

110

120

130

140

150

160

170


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sides and, as always, it will be a nail biting, bluffmanship, go to the matt set of

negotiations. Failure is not an insignificant probability.

InvestmentConclusionsThe uncertainty described above necessarily creates a very nervous environment

for investors. Money does not like such uncertainty. Investors, more than ever, will

have to grapple with these issues, having no clear idea how it will play out.

In the case of the U.S., politicians are returning from summer holidays to face a

surly electorate. They must deal with deteriorating employment, production and

housing conditions and a wobbly stock market. Policy change is inevitable within the

constraints of a Republican/Democrat partisanship.

Federal Reserve resumption of quantitative easing, (i.e., buying bonds and

mortgages) to inflate its balance sheet further is inevitable (Chart11). As the Feds

balance sheet increases, banks will get more reserves, but continuing financial

constipation means not much money growth will come out the other end. However, the

action could boost financial markets and confidence for awhile. Voters might also feel

better temporarily.


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CHART 11

Further fiscal stimulus initiatives by the Administration will be exploited by

Republicans on deficit bashing grounds. Therefore, Democrats will have to be creative

to seduce enough Republicans to get the votes they need. Small business subsidies

and housing would seem to be the easiest targets to get quick and popular action.

Protectionist measures are probably inevitable, but in the short term, there will be a lot

more talk than action.

Debt forgiveness on under-water mortgages has been mooted. Another

moratorium on mortgage foreclosures is possible. There are lots of things that could get

congressional support and have a quick impact (i.e., November use-by date) but, like

previous measures, would only buy a little time. After all, 14% of mortgages are in

foreclosure or delinquent. The estimate is that there will be one million foreclosed

homes this year. Without some support, the brief stabilization of housing prices will

end.

U.S. FEDERAL RESERVE ASSETS

2005 2010

500

1000

1500

2000

2500

500

1000

1500

2000

2500


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As our readers well know, we have emphasized the critical importance of capital

preservation in this volatile, highly uncertain world. Within that conservative context, we

have been relatively bullish on risk assets. We think the time has come to add another

layer of caution to portfolios. The S&P 500 may well remain in an extended trading

range but we may be much closer to the upper boundary than the lower. Seasonally,

we are heading into a period when markets tend to be weak, and some important

declines have occurred.

At this point, an extended bear market is unlikely, though possible. Corporate

liquidity and profits have been, and still are, a good source of strength. But that is

yesterdays news. Analysts always lag behind when profits are peaking and that could

well be the case now with the rapid slowing of the economy. However, the market is not

expensive on a long-term basis.

The explosive rally in Treasury bonds has created an interesting situation in

several ways. The 10-year yield is down about 100 basis points to 2% and the 10-

year TIPS (real, inflation adjusted) yield has fallen from 1.7% to 1% over the last few

months (Chart 12). It is at a record low and compares with the 2.1% dividend yield in

the S&P. While most people compare nominal bond yields with dividend yields, the

conceptually correct comparison is with real bond yields because dividend yields are

inflation adjusted over time. The comparison shows that, if real bond yields remain

low, stocks are cheap on this basis. The observant reader will note, however, that the

last time real rates were this low was in early 2008, just before the stock market tanked.


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But that coincided with a move to over 3% in TIPS yields. A repeat anytime soon is

unlikely.

CHART 12 CHART 13

It should also be remembered that low and falling real interest rates are bullish

for gold. The recent decline in the real rate of interest has certainly supported gold

prices. But it is useful to note that gold has essentially gone sideways in recent months

(Chart 13) in spite of this tailwind of falling rates and the publicity surrounding huge

purchases of gold by several very high profile hedge funds and massive purchases by

retail investors.

Clearly, a sharp rise in real interest rates would be a major negative for both

asset classes. At some point, real interest rates will rise, either because deflation sets


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in3 or because the Treasury will have trouble selling its bonds as fears heighten over

rising debt levels. It is unlikely to happen for some time.

Putting all this together, it is clear that there are cross-currents that will continue

to affect the equity market and we prefer to shift toward more caution. Uncertainty will

continue to grow and plenty can go wrong on short notice. On the other hand, it is hard

to see where the positives might come from, other than another politically motivated

reckless reflation effort from the U.S. authorities. We use the term reckless in a long-

term sense. The U.S. simply does not have good options. Therefore, it will use the

tools it has, trading off short-term benefits for long-term risks. There is nothing new in

that!

Gold remains an enigma. It is still in a bull market, but one that seems to be

losing momentum. It is a highly popular, well-advertised asset and has become very

expensive relative to almost all other assets. It is, however, a demonstrated hedge

against financial meltdown and, as such, deserves an insurance role of 5-10% in

portfolios. But it is very expensive insurance; it will be volatile and could be a very poor

performer if instability fears abate.

Miscellaneous Thoughts:

The sharp move up in bond prices in recent months in reaction to the well-

3Priceinflationcanbecomenegativebutnominalratescannotfallbelowzero.


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publicized economic slowdown makes bonds vulnerable on a short-term basis.

However, long-term investors should continue to hold positions because bonds

are doing what they are supposed toprovide safe income and a hedge against

deflation. As a result they are a very good portfolio diversifier in this

environment. Five and ten-year TIPS are poor value at near zero and 1% yields

respectively. Twenty-year TIPS are much better at 1.7% yield but they are at the

low end of their range and hence vulnerable.

Credit spreads have narrowed and do not provide much value unless skillfully

chosen. Junk bonds will experience increased risk as the economy deteriorates.

The U.S. dollar should continue to weaken as further Fed balance sheet

expansion occurs.

Commodities (including oil) have more downside than upside potential as the

economy slows further. However, the China slowdown is now a fact (Chart 14).

Price inflation has eased sharply (Chart 15), the housing bubble has been

pricked and exports are surging. Look for China to reverse monetary tightening,

the stock market to increase and demand for commodities to start rising again.


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CHART 14 CHART 15

The controversial Australian mining tax is worth paying attention to by global

investors who favor the resource sector as a long-term bullish play on world

competition for these assets. While the ruling party in Australia lost seats in the

recent election, the tax is not dead and has many supporters. In a world of

desperate governments hungry for tax revenues, fat profits of resource

companies are a tempting target. The old argument that such profits are a

windfall on a depleting asset would play well to a large part of any electorate.

Canada went through predatory government action against resource companies

in the 1970s and again in Alberta a few years ago with an ill-fated increased

royalty tax on energy. A left-leaning government in the future may well be

tempted again.

While Canada has deservedly had a good ride in recent years particularly

through the global recession, due to strong Federal Government finances and a


CHINA: LEADING INDICATOR15/07/2010

2005 201096

98

100

102

104

106

96

98

100

102

104

106


CHINA: PRODUCER PRICE INDEXLatest: 15/07/2010 (Annualized % Change Q/Q)

2005 2010-40

-20

0

20

40

60

-40

-20

0

20

40

60


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strong balance sheet, all is not quite as rosy as meets the eye. Chart 16 shows

that, while the U.S. savings rate has gone from 2% to 6.5% since 2007, the

Canadian savings rate, after a brief rally, has collapsed to about 2 1/2%.

Canadian households have continued to add to their debt, oblivious to the

changed world environment. House prices rose to new highs during the

recovery, while U.S. house prices are down over 30% from their peak.

Moreover, while federal debt levels and trends are good by world standards,

provincial debts are disastrous. There is even some talk of Ontario going the

way of California. Its per capita public debt is ten times that of California whose

bonds are rated slightly less risky than Croatias.4

CHART 16

4NeilReynolds,Ontario,NotUnlikeCalifornia,isGoingforBroke,(TorontoGlobe&Mail,August25,2010:

B2).


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In summary, continue to focus on wealth preservation. Increased caution is

warranted.

Tony Boeckh / Rob Boeckh

Date: August 27, 2010

[email protected]

New Book by J. Anthony BoeckhTo order a copy, please visit:

Amazon Barnes & Noble Borders Indigo


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