The Supercycle of Debt
Debt and the dollar, employment and interest rates, the US economy and world trade, money supply and inflation/deflation, taxes, deficits, commodity prices, politics, war, regulation plus a host of other variables. They are all related in a very complex and dynamic fashion. Changing one of them may change each of the others in often unpredictable ways, which in turn affect all the others. Today, we start a series trying to understand how they fit together and what the implications are for our investments.
We are in a stimulus driven recovery. As noted last week in my 2004 predictions, I think it will last for most of this year, if not the entire year. Yet, easy money and stimulus are not without a price. Messing with a free market is a perilous task. On the other hand, to have not acted would have insured a double-dip recession of what I think would have been of serious proportions. Will the stimulus be enough to start a self-reinforcing growth cycle? The task immediately before us is not to determine the correctness of any one policy. That is for the debating society and later letters. But for now, we need to see what the effects of the current trends and policies are likely to be.
The Butterfly Effect is the theory that the flitting of a butterfly in Costa Rica can change the weather patterns for the world. Everything is connected to everything else. It makes for an interesting New Age proposition or a late night philosophical conversation.
But the items mentioned in the first paragraph above are not butterflies. They are not even whales. They are volcanoes and earthquakes and ocean currents. They are the fuel and engine and tires and transmission of the world economy, not the fine Corinthian leather or color of the paint. (Aah, the maroon Cordoba of my youth - I must admit these less important items were of considerable importance to me.)
To set the table for our discussions, let's look at two quotes. The first is from the respected (and currently quite bullish) Bank Credit Analyst. As part and parcel of their views, they have an over-riding theme on what they call the Supercycle of Debt. This view is widely held by many market observers, including me, but their explanation is far simpler than most. Let me quote from their recent January issue (www.bcaresearch.com):
A Primer on the Supercycle
"The Supercycle is a description of the long-term decline in balance sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a build-up of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity.
"Government policies to smooth out the business cycle were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that the balance sheet imbalances and financial excesses built up during each expansion phase were never fully unwound.
"Periodic 'cyclical' corrections to the trend occurred during recessions, but these were not enough to reverse the long-run trend. Each time that liquidity was rebuilt during a recession, it failed to bring the level back to the previous recovery high. Meanwhile, the liquidity rundown during the next expansion phase established new lows.
"These trends led to growing illiquidity, vulnerability and volatility in the financial markets. The greater the degree of illiquidity in the economy, the greater the threat of deflation. Thus, the bigger that balance sheet excesses become, the more painful the corrective process would be. So, the stakes have become higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means are available. The Supercycle process is driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation."
From there let us go a quote brought to my attention by Michael Lewitt in the HCM Market Letter by economist Joseph Schumpeter. Schumpeter was a famous economist who brought us the insight that capitalism is a form of Creative Destruction, which we will look at in more detail below. As you read the following, think about the nature of our current recovery. Is the stimulus for the current recovery real or is it artificial?
"Our analysis leads us to believe that recovery is only sound if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own." - Schumpeter
Liquidity, as used by BCA, refers to the ability of businesses and consumers to put their hands on cash, either for purposes of investing or consumption. The appearance of home equity loans and mortgage refinancing has the effect of increasing liquidity. It clearly created a great deal of consumption in the late 90's and more recently, in the massive wave of re-financing last year.
But once debt is used, that source of liquidity is no longer available until the debt is repaid. As noted last week, predicting the demise of the American consumer has been a losing bet, but that does not mean that all is well. Much of the available liquidity in the form of debt has been used. How much more is available? No one knows. But let's look at some numbers from Applied Income Sciences in San Francisco:
"U.S. consumer debt is at a historic high. Excluding mortgages, the average personal consumer debt is about $18,654 per person. This is up more than 41% from 1998. The cost of servicing consumer debt is also at record levels: the average American now spends 18.1% of their disposable income servicing personal debt."
US household debt as a percentage of GDP has risen from below 50% in 1984 to almost 90% today, almost doubling in the process. That is in just 20 years. From 1964 to 1984, debt as a percentage of GDP was essentially flat, rising only a few percentage points.
Clearly debt has played a large part of the growth of the last two decades, and is equally important in the sustained consumer spending of the recent recession. The recent ability of consumers to access debt in the midst of a recession was unprecedented in world economic history, and along with the housing boom was responsible for a very mild recession. The US government and the Fed applied a very powerful cocktail of stimulus from low interest rates, tax cuts and deficit spending. The rest of the world obliged by buying our national debt in massive amounts. Combined with consumer debt, it worked to produce a recovery, and recently a most powerful one.
The Thighbone of Jobs
The old spiritual goes "the thighbone is connected to the hipbone" and so on. The key factor as to whether the stimulus of low rates and tax cuts will be viewed in the future as real or as artificial is whether or not the economy can produce jobs. Everything is connected to jobs. Consumer spending is connected to jobs. Without income growth which comes from jobs, consumers cannot continue to borrow and spend. Consumer sentiment is tied to jobs. The housing market is tied to employment as increased employment will increase the demand for housing.
Tax receipts and thus reduced deficits are obviously tied to employment. The more people who work, the greater the amount of total US savings. Increased employment is a key factor for business spending.
But the recent employment report is not an optimistic one. And if you delve deeper, it is even more problematic. My friend John Vogel sends me a detailed analysis of the employment numbers each week, often within an hour or so of the release. For the last 26 weeks, we have a comparison of 383,195 for the most recent period versus 407,788 for the prior year. 24,000 per week lower is not anything to be jubilant over. Note that both numbers are close to the 400k that economists use to determine job creation thresholds.
The economy, coming off the most powerful quarter in decades, produced a paltry 270,000 jobs. As Stephen Roach notes, "There seems to be a real disconnect between the actual numbers on the hiring front and the impressions that have been formed in financial markets. Total nonfarm payrolls have expanded by only 328,000 workers over the August to November 2003 period -- an average of 82,000 per month. That's far short of the pace of job creation that normally occurs at this stage in a business cycle recovery -- somewhere in the range of 250,000 to 300,000 per month. Yet many have been quick to interpret the recent modest pickup in hiring as a sign that Corporate America is finally breaking the shackles of risk aversion and emerging from the funk of recent years. The mix of recent hiring trends tells a very different picture.
"It turns out that fully 84% of the total increase in nonfarm payrolls over the August to November period is traceable to hiring in four segments of the labor market -- the temporary staffing industry, health, education, and government -- where combined jobs have increased by 68,000 per month. In other words, the bulk of the so-called hiring turnaround since August has been concentrated in either the contingent workforce (temps) or in those industry groupings that are least exposed to global competition. This hardly speaks of a US business sector that has consciously made an important transition from downsizing to expansion. It merely reflects the fact that scale is increasing in the most sheltered and least productive segments of the economy." (www.morganstanley.com)
Read that last paragraph again. The let's tie it to a small item buried in last week's Dallas Fed report. In the latest period, the average wage for temporary labor was $13.50 per hour versus $15.00 per hour a year ago. Further, maybe due to internet purchases, there were actually 72,000 less workers in the retail sector (think Christmas). This is distorting the seasonally adjusted numbers, which is why looking at averages of the real numbers as we did above is important.
GregWeldon offers us these tidbits about employment: Real earnings deflated in December by 0.6% and rose at less than an annualized 1% for the last four months. The slicing and dicing the Philly Fed report, which somehow was spun as positive, "...the reading posted by the Number of Employees category, FELL, as did the reading for Average Workweek. Perhaps even WORSE, is the decline in the expected Number of Employees, as the 6-month outlook fell to 15.1 from November's 17.5 ... marking a sizable drop from November's reading of 21.3. Also, the 6-month outlook for the Average Workweek fell to 16.7 from 24.6.
"Bottom line: Firms have become LESS optimistic about HIRING."
The employment numbers for the rest of this quarter are especially critical. There is a massive new supply of government bonds being sold in February. Will the employment number turn bullish and thus push up rates? Maybe just more of the same old sideways? Or will numbers surprise on the downside? What will that do to the stock market? Won't that make a difference on the dollar? But that affects rates again and the trade deficit, which drives the global economy and exports and so on and so on. It's all connected, gentle reader.
I believe the economy will be ok this year because of the stimulus from 2003 and the continuance of the tax cuts, at least through the elections. But I worry about the longer term sustainability of the recovery unless we start to produce jobs at a faster pace. When almost as many people drop out of the job market as are hired at new jobs, that is most worrisome. When incomes are not rising and hours worked are falling, as is the case for the most recent periods, that is troubling.
When you couple that with the most recent CPI numbers, which shows deflation is not yet wrung out of the system, it is most disconcerting for the longer term view. Again summarizing from Weldon's latest missive, the rate of change for all-items CPI for the last three months was zero. The trend for the last year is decidedly down. Core CPI (less food, energy and rents) is making new all-time lows, and is on the verge of outright deflation.
Now I can hear you muttering "What else is there but food, energy and rent?" which is an excellent point. From the list, there are apparel, transportation (used cars prices are down 21% over the last 6 months!), recreation and services, to name a few. The point is that for a significant part of the economy, deflation is close.
If you look at the numbers from Europe and Japan, deflation is also on the rise. Thus, it may not be surprising that interest rates, in the face of a falling dollar and rising deficits, are actually going lower. Yes, foreign central banks are buying massive amounts of US debt. Even Brazil is working to keep it currency from dropping against the dollar. In a world where the three main economic engines are supposed to be re-inflating their economies, there is curiously little inflation, if you can believe the government statistics.
But I agree with Marti Barnes of the Bank Credit Analyst when he writes:
"As far as monetary policy is concerned, the Fed has already made it clear that it is prepared to go to extreme lengths in order to prevent the economy from slipping into deflation. If the Fed wants to create inflation, then it can do so by drowning the financial system in excess dollars. Of course, the dollar would collapse, but that would be part of the reflationary process. An end to the Supercycle would be deflationary, so one way to delay the end would be to create inflation in order to devalue the burden of outstanding debt. The bottom line is that the demise of the Supercycle is not imminent. The economy will suffer another downturn in the next few years, but the authorities should still be able to find ways to prevent a terminal shakeout."
When to Buy Gold
I have been bullish on gold for two years. I get asked all the time about when to buy gold. The answer is pretty much always "now is a good time," or on the next pullback add some more. The above process of the Supercycle is terribly bullish for gold in terms of dollars. It could be dramatically bullish, although I sincerely hope not. I still look for a more Muddle Through ending, but there will be inflation at the end of the process, and that is bullish for gold. If you are in Europe, you have not yet seen a bull market in gold. But I believe it will eventually translate itself into a bull market in other currencies as well.
Gold may go nowhere this year. Or it may continue its rise. I don't know short-term, but longer term, over the coming decade, I think there is plenty of room in the gold market. I would add to any positions on a systematic basis.
Bullseye Investing , Pasadena and Miami
I fly on Sunday to Pasadena to be with good friend Rob Arnott, who is celebrating a very successful year for his business. Pimco, those smart bond people, got Arnott to run a fund called the All Asset Fund, which has risen over 19.8% since inception in 2002. It now has over $1 billion, which is cause to celebrate. Arnott, who is also editor of the prestigious Financial Analysts Journal, is one of the smartest guys I know and has earned the recognition and success he has achieved.
I then fly home, where I continue to wade through almost 800 pages of manuscript for my new book, Bulls-eye Investing, which should be out in April. They tell me it will be more than 400 pages in final form, but working with double spaced, hand edited copy is really laborious. I have to finish the final edits in less than 10 days, as it must be on press in six weeks and then on to the stores! No pressure, of course.
I will be in Miami and able to meet with clients and potential clients on Saturday and Sunday, Feb. 7 and 8. Just reply to this message, and my bride (Eunice), will contact you and set up the meetings.
Your glad he does not have to worry about his job analyst,