The Problem of the Endgame

By: John Mauldin | Sat, Jan 15, 2005
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Last week we looked at my 2005 Forecast. This week, we ponder the far more interesting question of where I could (or will be!) be wrong and why and what would be the consequences.

This week's topic came about as I was talking on Tuesday with Van Hoisington of Hoisington Investment Management Company. He and Dr. Lacy Hunt had just published their 2005 Forecast and I considered it quite thoughtful. I called to ask if we could use it for next Monday's Outside the Box.

He had just read my forecast, and noted that we disagreed in a few areas. "That is precisely," I noted, "why I want to use it. Outside the Box is supposed to be about different ideas." While I think long term rates will go up, he and Hunt think they will be essentially flat or maybe even drop. We talked about this and some other scenarios, with both of us noting that we could be wrong on one thing or another. "The really useful thing would be to know," I said, "where we are going to be wrong."

Let's be clear about one thing: it is quite likely that one or more of my predictions will be wrong, hopefully because I was not optimistic enough. As Yogi Berra noted, "It's tough to make predictions, especially about the future." In today's complex world, it is especially tough.

For quick review, let's look briefly at last week's musings. I called the forecast "The See-Saw Economy" as it will take some precise balance and coordination amongst all parties to continue the game. (You can read the forecast issue at Forecast 2005: The See-Saw Economy.)

I think the economy is likely to grow around 3%, a little below consensus. I think long term interest rates rise, and the Fed increases rates more than most think, topping 4% before the end of the year, barring the beginning of an economic slowdown. Short rates rise faster than long rates, thus we see the yield curve flatten. Since the US and world economy should continue to expand nicely, demand for oil should increase or stay steady. Plus, OPEC really likes high oil prices, and running up to $50 did not do any material harm to their customers. Oil will go sideways in a volatile trading range with an average in the low to mid-$40's, but with the surprise to the upside.

I do not like the stock market in a rising interest rate and/or rising inflation environment. If we get both in the first half of the year, I really do not like stocks, but I tend to see another trading range year like last year, but this time with the pressure to the downside. (Along with my usual caveat that when a recession appears on the horizon, the market will start to materially slump. We just do not know when that will be - read more below.)

The dollar should bounce in the first part of the year until we can get some more dollar bulls, or at least wash out the bears, and then the dollar resumes it slide. Gold will do the inverse of the dollar. The trade deficit gets worse in the first part of the year. I wrote:

One Last Thought on the Trade Deficit

"A falling dollar will not be enough to cure the trade deficit. It will also take a rising savings rate from the consumer. What will bring that about? When the next recession comes in 2006 or 2007, the stock market will drop. Average drops during a recession are 43%. The Baby Boomer generation will realize that the stock market is not going to bail out their retirement hopes. They will stop spending and start saving with a vengeance. Problem solved, only it creates more problems. The world will not like it when the American consumer retrenches.

"Since the bond market usually anticipates the actual recession, which means that long term bond rates will fall, we should see an inverted yield curve prior to a recession. Major caveat: with Fed manipulation and foreign central bank buying, we are in new territory. The old rules may no longer apply, or be applied differently. Pay attention, gentle reader. This is one we will watch closely.

"As far as the end game, the short version is that once the recession starts, the Fed moves aggressively to stimulate the economy, brings back inflation and we get high rates and inflation. Over time, we end up in stagflation. Of course, we will hit the reset button, work our way through that and start the next big bull move. But all that is in our future. For 2005, we can enjoy the see-saw, and hope our partners don't jump off."

Let me note that I assume that no one would act on these predictions and then go away for the next 12 months. That would be the height of foolishness, as the facts will change. And as Keynes famously noted, "When the facts change, I change my mind. What do you do, sir?"So, where do I see risk in whether or not these predictions turn out to be true? I look to the West - across the Pacific - to Asia.

One of my principles for staring into the future is that in the absence of some new contrarian fact, history should serve as a guide. Looking at history, when the Fed raises rates at the short end, the long end more or less follows, rising along with the short rates.

It did not happen last year except at the shorter end of the yield curve. And this is puzzling. Short term rates rose 1.25%. The 2-year treasury rose from 1.88% to 3.1% and the 5-year note yields rose mildly from 3.28% to 3.6%.

But the ten year note behaved oddly. It started the year at 4.30% and ended the year flat at 4.28%, but rose to 4.80% by June 11, about the time the Fed started raising rates. It then proceeded to drop over 50 basis points from that point, while (again) short term rtes rose 1.25%. The 30 year (or longest dated bonds) dropped 0.25%. The usual reason given is that while foreign private investors in general have shunned US investments, foreign central banks (read Asia, especially Japan) are buying our treasuries in massive amounts.

History and other factors suggest to me that long term rates should rise as the Fed raises rates. I still believe so, but here is the chink in my forecasting armor.

Broken Relationships

Let's start with this note from the January 14 essay by Stephen Roach, (Chief Economist of Morgan Stanley). This is a partial quote. (You can read it in its entirety at by going to the archives.)

"...The diminished sensitivity of the US economy to currency fluctuations has been increasingly evident over the past 15 years. Normally, a weakening currency results in a narrowing of a nation's current account deficit and a pick-up in inflation. That's pretty much what happened in the 1970s and especially in the late 1980s in the aftermath of the dollar's sharp downward adjustment during most of that latter period. But then it all seemed to change in the 1990s. The dollar's decline in the first half of that decade was accompanied by a shift in the current account from surplus back to deficit. And inflation barely budged. A similar outcome has been evident in the past three years -- a 16% decline in the broad dollar index (in real terms) accompanied by an ever-widening current- account deficit and persistently low inflation.

"It's not altogether clear why this relationship has broken down. My suspicion is that globalization is the main culprit. (emphasis mine -JM) The globalization of supply chains biases import content to the upside for the high-cost developed world; it also forces the advanced economies to abdicate price setting at the margin to low-cost producers in the developing world. The result is a sharply diminished industrial base in countries like the United States. Manufacturing employment currently stands at only about 13% of America's private nonfarm workforce -- down sharply from the nearly 23% share that prevailed in the mid- 1980s, the last time the dollar entered a serious correction. Moreover, value- added in the US manufacturing sector fell to only about 14% in 1993 -- down from 20% in 1985. The sharply diminished size of America's industrial base makes it exceedingly difficult for the US to turn dollar depreciation into an advantage and trade its way out of a severe current-account problem through enhanced export growth and import substitution.

"Nevertheless, the global rebalancing construct that I endorse still assigns an important role to a realignment of major foreign exchange rates. In my view, a lopsided world economy needs a shift in relative prices in order to establish a new and more balanced equilibrium. Currencies are nothing more than relative prices, essentially comparing the fundamentals of one economy versus another. With the dollar the dominant relative price in the world today, a depreciation of the greenback is necessary for global rebalancing. And, based on current account adjustments of the past, there's good reason to believe that the broad dollar index has a good deal more to go on the downside. However, due to America's reduced currency elasticities [the relationship he spoke of earlier - JM], a weaker dollar no longer appears to be a sufficient condition to complete the global rebalancing process.

"If a weaker dollar can't do the trick, what can? The answer, in my view, is real interest rates -- the price adjustment that could well qualify as the sufficient condition for America's role in global rebalancing. The only way America can ever get a handle on its trade and current account conundrum is on the import side of the equation. After all, imports are currently 52% larger than exports (in real terms), making it almost mathematically impossible for the US to export its way out of its trade deficit.

"Given the asset-dependent character of US domestic demand growth, the interest rate connection becomes all the more critical as an instrument of rebalancing. Higher real interest rates will not only curtail the pace of asset appreciation but will also raise the cost of debt service -- thereby exerting twin pressures on the asset-driven portion of domestic demand. Needless to say, the saving- short, overly-indebted, and asset-dependent American consumer should feel the impacts of such an adjustment most acutely. But homebuilding will also be hit, as will business capital spending to a more limited extent.

"So far, interest rates haven't budged nearly enough to spark a meaningful rebalancing of a lopsided world. I suspect that the Federal Reserve is about to lead the way in changing that...."

What Roach did not say (and perhaps does not mean) is that such events - homebuilding down, increased cost of debt service, flat or dropping home values - are likely to produce a recession. As I noted last week and again above, I think it will take a rising savings rate from the American consumer to really dent the trade deficit. I do not think that happens until Baby Boomers and those in their 40's see a serious stock market decline coupled with a decline in housing values. They then realize they will not be able to rely solely upon growth in their 401k stock portfolios and double digit growth in home values to get them to retirement nirvana. It is going to require savings and more savings.

Of course, the world and especially Asia will not like that. It will subject them to a recession as well, or at least a glut of capacity.

As an aside, let me pose an odd question. I think the dollar will weaken, as does Roach, and think it is necessary. But I don't run an Asian central bank. What if we do see a global slowdown as a result of the US consumer retrenching? Would it be so far out of character for some Asian nations to work to lower their currencies against a weak dollar? Could we see a recession and a rising dollar? When there is nobody in the central bank school yard, it is not altogether certain that the "kids" will play nice in the sandbox. Just a thought.

Party On, America!

Before we get to the real conundrum, let's jump to another essay released today by Paul McCulley of PIMCO. ( I think it is one of his more insightful ones. I highly suggest you read it. Jumping to the middle:

"...Which brings us to Macroeconomics 104, where we learn that private foreign net investment in America is putatively a good thing, while a large share of foreign official investment flows in America's capital surplus is ostensibly a bad thing. Why?

"Foreign private investors in America are theoretically profit-maximizers and are coming to America to make profits, which is a sign that investment in America must be more profitable than in other places.

"In contrast, foreign official investors in America are not profit maximizers, and are lending America money as an act of mercantilist self interest, so as to keep their own currencies undervalued, thereby giving their exporters an "unfair" advantage against American producers.

"Accordingly, we also learn that the greater the official share of America's capital account surplus, the more unsustainable it is, and therefore, the more unsustainable America's current account (or trade) deficit is. Why?

"Since foreign official investors are not profit maximizers, there is no assurance they will continue to lend America dollars if and when their non- profit motives change, generating a disorderly decline in the dollar and dollar- denominated asset prices and, therefore, a dark winter for the American economy.

"Now, finally, we have the theoretical prerequisites to register for the Senior Seminar, in which we try to apply what we have learned to the real world. And the first thing we learn is that the real world is a lot messier than the textbook world!

"In present circumstances, the Fed's dilemma is either to: (1) downgrade, if not reject, its mandate to foster full employment in America, or (2) pursue that mandate with the virtual certainty of an ever-larger U.S. current account deficit, exposing America to the risk that foreign official investors suddenly decide, for their own non-profit maximizing (political?) reasons, to let a plunging dollar plunge America into a recession (depression?).

"Which, of course, would result in the antithesis of the Fed's mandate to foster full employment in America.

"So far, the Fed has chosen to honor its duty to pursue full employment in America, underwriting the risk - repeat, risk! - that foreign official financing of America's current account deficit becomes less agreeable. I firmly - very firmly! - believe the Fed has made the right choice, even as I respect others that feel differently.

"I do not view foreign official investors in America as either strangers or acting out of kindness, but rather people we know who are acting in their own national interest: doing the only thing they can do to support their job creation, unless and until they discover the joys of more robust domestic demand growth.

"In contrast, I've long worried - much more than most! - about a different risk arising from current global circumstances, in which America must party in order for the world's party staff to find employment: the risk of asset price bubbles, which ineluctably become asset price busts.

"Indeed, I've long believed that asset price bubbles are not just a risk, but also a virtual certainty stemming from current global circumstances."

He then goes on to note what virtually every Fed watcher has written about since the release of the December 14 Federal meeting (I commented on it last week): various members of the Fed are clearly worried about a number of things. Lack of savings, lack of foreign consumption, potential inflation, trade deficits, US government deficits and so on.

But let me again quote the real eye-opener from the minutes:

"Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums."

In the past week or so, I count no less than three Fed governors in major speeches who have said that there is no commitment by the Fed to only raise rates at a measured pace of 25 basis points. Coincidence? After reading those minutes, I would highly doubt it.

You think there wasn't some talk at the bar late at night during the meeting? Three Fed governors on their own decided to talk about the risks to a "measured pace" of rate increases within one week of each other? At least a few parties felt the need to give the markets a heads up.

Couple that with Alan Greenspan's warning last November (after the election) in Frankfurt: "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money." I think it is pretty clear. Not only does the Fed intend to keep raising rates, but they are hinting at the possibility of a faster rate of increase than 25 basis points per meeting.

Going back to McCulley for a few more thoughts (as he says it much more clearly than I). Noting he hoped he was wrong in his assessment:

"But hope is a poor excuse for an insurance policy. And when central bankers start musing publicly about asset price inflation (risk premium deflation), asset managers need insurance!

"And in the present circumstances, that means getting prepared for an increase in volatility in financial asset prices, both stocks and bonds (and maybe, currencies, too).

"Indeed, the most benign interpretation of the FOMC's intent in mentioning the possibility of 'excess risk taking' is that the FOMC - read, Chairman Greenspan - wants to interject some fear into the financial markets."

OK, we have set the stage. Now let's see how our characters act out the play.

Let's speculate that the Fed raise rates by a buck and half (1.5%) over the next 6-8 months. If long term rates rise along with the process, even if somewhat slower, then my forecast (for this year) is largely intact.

But what if Hoisington and Hunt are right? What if long rates stay flat or even drop? Then we get fairly close to an inverted yield curve. A small bump in the economy, some softness here and there, and voila! We watch as the curve inverts for 90 days. And then everyone but Blue Chip Economists note that a recession is likely within 9-12 months.

The Problem of the End Game

McCulley has put his finger on it. It is the problem of the endgame I have been writing about for three years. The Fed can either let the asset bubble (housing, carry trade, etc.) continue and it will eventually go the way of all bubbles (with much weeping and wailing), or they can begin to decrease liquidity and hope for a soft landing.

They have already started the process. Interest rates are rising and they are hinting at an even faster pace. The adjusted monetary base has been flat for five months. Absolutely no growth. That is not the stuff of inflation.

Yet the risk is that the process of trying to let the air our of a bubble is not that easy to control. They have been successful with only one soft landing in the last 40 years in the mid-90's, although the recession of 2001 was quite mild considered we had come off a huge asset bubble in stocks.

Raising rates will put downward pressure on housing, certainly will not help corporate profits and will make the cost of debt service higher. It is a game of chicken with the economy. If you allow inflation and an asset bubble, you make the recession which will inevitable follow much worse. But can you keep from causing a recession by deflating the asset bubble in the meantime?

There is much hand-wringing in certain circles about the US depending upon the kindness of strangers - that we are dependent upon them financing our debauched spending spree. By buying our bonds (those inscrutable Asians), they keep our rates lower than they would otherwise be. What if they decided to stop buying our bonds?

The opposite is just as big a problem, though. What if they continue to buy our bonds and long rates do not rise, thwarting Fed policy and we see a continuation of the asset bubbles the Fed (and any thinking observer) worries about? If the yield curve flattens, that is certainly not good for many financial institutions and their profits, which I should note makes up a large percentage of the S&P 500.

And that's my worry. That is what could kill my rather optimistic forecast for 2005. The Fed raises rates at a more than measured pace and long rates do not rise gently along with them. That will surely soften the economy by the end of the year. Rather than pushing the end game out for another year or two, we start looking down the considerable maw of the recession dragon.

Of course, I doubt whether we can actually get a soft landing, given the extent of the imbalances. One way or another, we end up in recession. But we do not want one as a result of an asset bubble breaking. The Fed must pick which poison we risk while trying to avoid having to take the medicine. How we get an increased US savings rate (which is required to balance or at least mitigate the trade deficit) without a recession is beyond me. But you can bet the Fed will try.

But that doesn't mean I don't root for the home team. I hope they confound me! I hope I am being overwrought and way too bearish. A soft landing - something like 93-94 - sounds quite nice.

It is somewhat analogous to my Texas Rangers, as unbalanced a ball team as there is. We simply have no pitching. It is not realistic to think that we will see a World Series at the Ballpark this fall. I will still root for them, but I don't bet on them. But getting into the play-offs - a soft landing - would be nice.

China, California and a Few Details

My business partner from England, Niels Jensen of Absolute Return Partners, comes to Texas next week. I will introduce Niels to real steaks, cheap currency and Texas hospitality. Then we are off to La Jolla to meet with my US partners, Altegris Investments and then off with them to a long weekend planning session.

I will write next week's letter a little earlier in the week, as I will not have time next Friday. I have been gathering data for a letter on China for sometime, and I think you will find it interesting. At least it will be a nice departure from today's rather gloomy topic.

Next week promises to be a time with good friends, good food and a few visits to Jon Sundt's (the president of Altegris) great wine cellar. I do so appreciate a man who put up a wine 20 years ago just to break a few bottles out for my visit.

Your thinking cabernet and prime analyst,


John Mauldin

Author: John Mauldin

John Mauldin

John Mauldin

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