DEEP THOUGHTS FROM DAVID ROSENBERG

DEEP THOUGHTS FROM DAVID ROSENBERG

Courtesy of The Pragmatic Capitalist

Rosey was really on point yesterday with these excellent thoughts:

We realize that the nerdy economics term of “The Great Recession” has already been coined, but let’s face facts — this was not a recession, nor was it great. It was not the Great Depression, either, but it was (is, in fact) a depression. So let’s call it the “Not So Great Depression”.

Now what makes a depression different than a recession is that depressions follow a period of wild credit excess, and when the bubble bursts and the wheels begin to move in reverse, we are in a depression. A recession is a correction in real GDP in the context of a secular expansion, which is what all prior nine of them were, back to 1945. But this was not a mere blip in real GDP — it is a post-bubble credit collapse. This is not a garden-variety recession at all, which an economic downturn triggered by an inflation-fighting Fed and excessive manufacturing inventories. A depression is all about deflating asset values and contracting private sector credit. In a recession, monetary and fiscal policy works, even if the lags can be long. In a depression, they do not work. And this is what we see today.

The stock market typically rolls over shortly after the last Fed rate hike at any given cycle. That didn’t happen this time. The Fed last hiked rates in the summer of 2006 and yet the stock market didn’t peak until after the first rate CUT … that does not happen in a normal cycle.

Even with a 0% funds rate, the economy could still not turn around, and that is exactly what happened in the 1930s in the U.S. and in the 1990s in Japan. When the central bank takes rates to zero and that does not do the trick in helping the economy or the markets find the bottom, and then has to engage in an array of experimental strategies and radically expand its balance sheet, then you know you are in a depression.

Moreover, when, a year after the onset of quantitative easing, we see money velocity and the money multipliers still in decline, then you also know that the liquidity is not being re-circulated in the real economy but perhaps finding a home in risk assets, which is why you can have a de facto 10% unemployment rate and at the same time a 70% rally in the equity market. This process cannot last indefinitely and already we have a situation where, on a Shiller price-earnings basis, the equity market is as overvalued now as it was in September 1987. And that correction that ensued back then took place with 7% real GDP growth and a 50%+ trend in corporate earnings.

The vagaries of an overvalued market is that good news may no longer be good enough — and viewed as an opportunity to take profits. When this strategy occurs en masse — well, look out. And in extremely overvalued markets, it doesn’t take much. Food for thought — think of the risk involved before chasing the performance of the past year.

Of course, when there is fiscal stimulus of 10% relative to GDP in the U.S., and 3.5% of stimulus globally, together with bank bailouts and government support for housing and autos, then it’s a no-brainer that for a while it is going to feel as if the worst is over and that we are entering a new world of prosperity and tranquility, which is what a 17 reading on the VIX index symbolizes (the same level it was at when the market peaked in October 2007, come to think of it).

Nothing could be further from the truth. We have a situation where banks that are allegedly to-big-to fail have been protected, accounting rules changed in mid-stream, the government buying stock in auto companies and financial service firms, buying automobiles, declaring foreclosure moratoria and loan modifications ,which ensure that the real estate market will not clear and thereby forestall price discovery.

The problem is that all this fiscal largesse, intervention and incursion cannot go on indefinitely because there are limits to what the taxpaying public will support in terms of policy. Trying to get people to buy a home when the homeownership rate is still well above the long run average; trying to spur auto consumption when 20% of the households in the U.S.A. are already a three-car family — these policies aimed at reviving a defunct cycle of over consumption is starting to be viewed as a colossal waste of taxpayer money.

No doubt efforts to support the swelling ranks of the unemployed are going to remain critical, not just as income support but to ensure that they can be retrained too. We are already at the point where a record of nearly 20% of personal income is coming from government transfers — the government will have to make some serious choices about how it is going to allocate its fiscal resources going forward because the appetite for more public debt is beginning to wane. The government cannot fight human nature for ever. In fact, all the Obama team has managed to really buy is time.

But it does look like the fiscal tightening morphs into tightening sometime around mid-year because the mathematics with deficits is that if you go from $1 trillion to $1.4 trillion in a year, you just added some stimulus; just to prevent fiscal withdrawal from economy, the deficit for the next year has to stay at $1.4 trillion just as an example. The problem of course is that even if the deficit were to stay at $1.4 trillion that adds 10 percentage points to a federal debt/GDP ratio that exceeds 100% by 2011. Chart 3 shows where the Office of Budget Management (OMB) sees the government debt/GDP ratio heading in the next decade under the status quo — try 107%. Think of the future tax liability that would impose on workers and investors. And think of how quickly voters would be to support the next round of stimulus if the chart below were presented to them.

To be sure, the question gets asked as to what Mr. Market sees that we don’t see. As we said, in the past, market peaks tend to occur when we have had the classic blowoff phase, which takes the Shiller normalized P/E ratio to a level that is 50% overvalued.

Currently, the market is 27% overvalued on a Shiller basis. So, as expensive as it is, it could easily get even more expensive, which would mean a final test of around 1,300 on the S&P 500. This part of the cycle is best left for day traders or massive risk-takers and not for serious long-term investors. The S&P 500 did not hit its peak until October 2007 and for at least a year, was either in denial or completely oblivious to what was happening to the economy:

• Home prices were already down 7% from their highs

• The ABX indices were imploding

• Financials had already rolled over from their peak (as they have already back on October 14 — now there’s a canary in the coalmine!)

• The credit crunch was already in full force as highlighted by the events surrounding BNP Paribas and those two Bear Stearns hedge funds

• The money market had blown up right in the Fed’s face forcing an unexpected cut in the discount rate, followed by a cut in the funds rate

All the while the equity market was still in the process of making new highs and the bears were too busy having an apoplectic fit to hear the derision from the crowd of bulls as to how wrong they were. That is now history; and not too long from now, today will be too.

In retrospect, the bears were not wrong — the market was irrational. And that is with the benefit of hindsight. Everybody thought John Paulson was wrong too in those years when he was positioned for a housing collapse — but he was right, wasn’t he?

Now is definitely not the time to live in the moment, to start hyperventilating and to begin to chase this market to a bubble peak; now is the time to think about what the economy is going to look like in a post-stimulus world because the only thing we know is that the Fed and the government, at this juncture, intend to start pulling back on their support for the housing market at the very least at the end of March. At that time, we will see what the emperor — the U.S. economy in other words — looks like disrobed. And think of how ugly that picture is likely to be if the Beige Book can, at best, describe the current macro backdrop as being “at a low level economic activity” in view of all the government stimulus out there in support of a boom.

EARLY STAGES OF THE DELEVERAGING CYCLE

Adjusted for inflation, the total amount of U.S. debt overhanging the economy and the capital markets has declined in the past two quarters. But at $185,000 per worker, and it is the worker that is going to be the one to bail everyone out, this is triple the historical norm. At least what the norm was before the swelling of the securitization market, the breakdown of Glass-Steagall and the proliferation of buy-now/pay-later mortgage products.

Looking at Chart 4, it suggests that even with the cushioning impact from the blowout of the government balance sheet, the process of deleveraging from what is still a near-record debt overhang is going to take a long period of time and exact a toll on economic activity along the way. The chart includes ALL debt and it is going back to $60,000 in real terms, and if it’s going there, and we get a withdrawal of stimulus at any time, then the credit contraction is going to gain some serious momentum. This is a big reason to be defensive and yield-oriented in the portfolio.

For more on this file, have a look at Gillian Tett’s column on page 20 of the FT — this is the real deal: Deleveraging Out of the Debt Mire Will be An Unsavoury Task. And we also highly recommend a read of today’s Lex Column in the FT. It cites a McKinsey report that analyzed 45 other historical examples of deleveraging and found that in the absence of war, default or a move to hyper-inflate, the average length of time the country spends in its deflationary deleveraging phase is seven years in the aftermath if its crisis, and that the total debt/GDP ratio is sliced by one-quarter.

Now, Chart 4 is debt in real terms and looked at on a per worker basis; Chart 5 is total debt divided by nominal GDP and it looks quite similar — the ratio is at 369% and it peaked in the first quarter of the year at 373%. Slicing this by one-quarter would take the ratio down to 300%, which would mean going back to the levels that prevailed just before the post-WWII secular credit expansion turned parabolic in 2002. That hardly seems Draconian and would still leave the national debt/income ratio well above historical norms. But the process of debt reduction would drain nearly $10 trillion out of the economy. How you come up with a bear market in bonds or inflation under that scenario would require a complete re-write of the economics curriculum across every university and college in the country.

As the chart below illustrates, real federal debt in relation to the worker population has gone where it has never gone before — over $40,000 (in excess of $90,000 in nominal terms). Not only is this triple what was is normal in the distant past, but this is double the ratio that immediately preceded the credit collapse in the private sector and the accompanying recession.

Of course, the bad debts in the private sector were made by bad decisions by borrowers who had no business adding to their debt loads and by lenders who believed that parabolic asset inflation would render even the lowest FICO score a reliable credit. This debt is being extinguished now but not nearly at the rate that it was taken on during the bubble years, and people have figured out that they can just stop paying their mortgage and they won’t be kicked out for at least a year, so why not enjoy some free shelter for the time being? The government is ultimately going to move towards the “cramdown” or principal writedown route because the current process of modifying loans and merely reducing the monthly payment is not addressing the curse of all foreclosures, which is negative net equity.

But credit is contracting in the private sector, especially in the consumer space, to a lesser extent in the mortgage space, but the process of reducing private sector debt is ongoing and this is why forecasts of any sustainable recovery are so off-base. What looks like a recovery right now is merely the by-product of a massive government incursion into the economy and capital markets to try to offset the credit contraction underway in the private economy. However, this process may not last because the 70 million households who have no mortgage debt, and the 45 million who do have a mortgage but are not in the foreclosure process (not to mention the 140 million tax filers), are the ones that never really took advantage of the opportunities offered during the credit insanity. But they will ultimately be the ones that are going to have to eat this vertical jump in the public’s debt tab. The government is not a corporation — it is the people.

When it comes to using the taxing authority as the backing source for the massive amount of federal debt that is being issued to cushion the blow triggered by the collapse if the credit bubble, it is the working stiff that is going to paying the piper. But while there is a view that the government has some sort of enduring printing press or some sort of unlimited fiscal capacity, the answer is no — that is not the case. While public debt is backed by the taxpayer, the question must be asked what happens when the taxpayer says “sorry, I already gave at the office.” The Senate vote on January 19 may be a referendum on the general public’s concern over the implications of running up a fiscal tab that could threaten the country’s future prosperity to curb today’s consumer deleveraging pain — a mini Tea Party of sorts, which is why the vote is being held in the right state.

As the Lex Column concluded in today’s excellent “rant” on the deleveraging cycle, “it may be economically and politically sensible for governments to spend money on making life more palatable at the height of the crisis. But the longer countries go on before paying down their debt, the more painful and drawn-out the process is likely to be. Unless, of course, government bond investors revolt and expedite the whole shebang.”