A Damnation in Disguise
This expert’s principal concern – regarding the U.S. financial and real estate markets – is precisely that the economy is as strong as everyone predicts. How can that possibly be?
If the Fed continues to print money at the rate they have done in the last couple of weeks, there is a chance – given that the global economy is, while unbalanced, nevertheless in a strong synchronized growth mode – that inflationary pressures could accelerate far more than is currently expected.
In this instance, inflationary symptoms would show up in sharply rising wholesale and consumer prices and not necessarily in rising asset prices, such as real estate. In other words, inflation would migrate from the asset markets to consumer prices and lead to far higher interest rates and, possibly, to a rout in the bond market, as has already happened in Japan, where JGB bond yields have risen by more than 300% since June 2003, knocking off bond prices!
Now, in the case of Japan, the more-than-tripling in bond yields coincided with a strong recovery in the stock market (up from less than 8,000 in April to around 11,500 recently); therefore, one could argue that, in the United States, further weakness in bonds, or even a collapsing bond market, may not derail a bull market in equities.
But there are numerous important differences between Japan and the United States. For one, I suppose that a rise in Japanese bond yields from less than 0.5% to 1.9% has hardly had an impact on the Japanese property market, since properties have rental yields of 6% or more.
Rising Global Inflation: Japan Was Depressed
In the United States, however, where rental yields are frequently below mortgage rates, I suppose that a rise in mortgage rates from 6% to 18% would have a devastating impact. (Such a rise in bond yields is, for now, inconceivable.) Also, when Japanese stocks and interest rates bottomed out a year ago, expectations in Japan about future economic growth were extremely depressed, bearish sentiment was at an extreme, and Japanese institutional investors and individuals were very underweighted in equities compared to bonds. Otherwise, how could one explain that, at the time, the Japanese stock market had a dividend yield of more than 1.5%, while bonds were yielding less than 0.5%?
May I remind our readers that in the 1940s, the Dow Jones Industrial Average had, at times, a dividend yield of 7%, while government bond yields fell to below 2%, indicating that growth expectations were then as low as they were last year in Japan. And in the same way that the 1940s represented the best short opportunity in one’s lifetime for U.S. bonds, I suppose that investors will never again see Japanese bond yields of less than 0.5%, and that from here on, interrupted by trading rallies, Japanese bonds will continue to decline for the next 10 years or so.
Over the last 12 months, as the bearish sentiment about the Japanese economy and its stocks began to dissipate, a massive shift from bonds into equities got under way. Admittedly, foreign investors largely drove this shift. In short, because Japan suffered from a severe asset deflation and a poor economic environment throughout the 1990s and until just recently, when its bond market bubble was deflated over the last 12 months, it did not cause any serious pain in the asset markets as the economy improved and deflationary forces dissipated. (Still, if interest rates rise much further in the immediate future, some pain may be felt – particularly in the banking sector, which still holds huge bond positions.)
In any event, I hope that the reader will understand the current fundamentally different conditions between Japan (which also enjoys a high savings rate and a huge current account surplus) and the United States, where asset prices didn’t deflate over the past 15 years, as was the case in Japan, but were instead inflated as a result of expansionary monetary policies.
Moreover, U.S. stocks have a far lower dividend yield than long-term bonds (high growth expectations) and households and financial institutions hold a far higher percentage of their financial assets in equities than in Japan.
Rising Global Inflation: Fueling Asset Inflation
To put it in very simplistic terms, whereas rising global inflation and interest rates are likely to be beneficial for the Japanese economy, whose problem was asset deflation, this is unlikely to be the case for the United States, where excessive debt growth fueled asset inflation and led to a highly leveraged consumer. In fact, my principal concern regarding the U.S. financial and real estate markets would be precisely that the economy is as strong as everyone is predicting.
In this scenario, I wouldn’t be surprised to see a repetition not of 1994, as is popularly supposed, but of 1973/1974, when corporate earnings expanded but stocks fell out of bed because of rising inflation and interest rates. (Watergate certainly didn’t help, but today’s geopolitical tensions are, in my opinion, far more serious.)
In this respect, it is important to understand the following.
Rising Global Inflation: Salaries Not Inflating
The Fed can largely control to what extent it wants to expand the money supply (print money), but it doesn’t control its consequences – that is, where the money flows to and which sectors of the economy inflate. (Admittedly, Mr. Greenspan has been able to inflate just about everything around the world.) Still, one sector that has not been inflating much, given the global competition for labor, is wages and salaries of the U.S. labor force.
Therefore, if expansionary monetary policies lead to a rise in the cost of living (not the CPI, published by the Bureau of Labor Statistics, which understates for political reasons the true rate of inflation), then real wages will continue to decline since cost-of-living increases are more likely to run at 5-7% per annum while wages are rising at most by 2-3% per annum. If this were to occur, the consequence would be that affordability will become a problem and households will have to reduce the rate at which they are spending, unless they choose to increase their borrowing.
But here comes the problem. In this scenario of declining real earnings but accelerating inflation (read stagflation), it is likely that the market – not the Fed – would force interest rates up considerably and that, therefore, the asset markets (notably real estate) may – if not decline – at least cease to appreciate at the rate at which they have done so over the last few years. As a result, the rate at which the consumer takes on additional debt will slow down or even decline (should consumers, for a change, decide to boost their saving rate).
The Federal Reserve Board is caught in a very difficult position. Continuous excessive money printing may not lead to a stronger economy but to declining real incomes and rising interest rates as inflation picks up. Conversely, resolute tightening moves could easily upset already overleveraged consumers and lead to a severe adjustment in the real estate market, whose appreciation has fuelled consumption since 2000. In fact, it would seem to me that, regardless of future monetary policies, the economy will disappoint, as the market mechanism has begun to take away the Fed’s job by tightening monetary conditions.
I might add that the Fed should never have had the authority to distort the free market for interest rates through monetary policies. Hopefully, the market mechanism is now powerful enough to render the Fed’s monetary manipulations irrelevant.
for The Daily Reckoning
August 3, 2004
"I don’t recognize the place," was our first comment. We once lived in Albuquerque, nearly 40 years ago. New Mexico was a strange place – one of the poorest states in the nation. People lived in ramshackle hovels and drove old pickup trucks.
But now there are houses everywhere…and new cars clogging up the streets. One street stretches for miles, lined with nothing but auto dealers.
How did people get so rich? We don’t know. Wages have scarcely risen, yet everyone seems to have a lot more money to spend…
More travel notes, after the news from Eric:
Eric Fry, from a city at risk…
– The hardy Dow Jones Industrial Average shrugged off terrorism threats and record-high oil prices to notch its fifth-straight winning session – the blue chip index’s longest winning streak since mid-December. Under the amber glow of an "orange alert," the Dow advanced 39 points, to 10,179, while the Nasdaq gained 5 points, to 1,892.
– Ironically, terrorism-focused stocks logged some of the day’s largest gains. Mace Security International (MACE), which makes pepper and tear-gas sprays, gained 6.3%, while DHB Industries (DHB), a maker of bulletproof vests and other body armor for our troops in Iraq, jumped 9.1%.
– Over the weekend, Homeland Security Secretary Tom Ridge raised the terror alert level to "orange," citing "unusually specific" evidence of possible attacks against certain key financial buildings, including the New York Stock Exchange. But the bulls would not be so easily cowed into selling stocks.
– Al Qaeda be damned! The if-you-sell-stocks-the- terrorists-win contingent was out in force yesterday, buying stocks in the name of war. Immediately after the opening bell, share prices charged into negative territory. But the patriotic lumpeninvestoriat repelled the sell-off and pushed the major averages back into the black. What’s more, the lumps maintained their buying even as crude oil prices set new all-time highs. September crude futures added 2 cents at $43.82 a barrel on the New York Mercantile Exchange, after advancing within a whisker of $44 a barrel.
– Curiously, yesterday’s anxieties produced precious little buying in the precious metals pits. Gold gained a mere 40 cents, to $394.10, while most gold stocks had very little to show for their 6½ hours of trading. Nevertheless, one savvy investment pro believes gold stocks are now in "bounce mode."
Jay Shartsis, professional options trader at RF Lafferty here in New York says, "Four gold stocks had ‘selling climaxes’ or bullish weekly reversals last week [They made new 52-week lows, but closed higher on the week]. They are ASA Limited (ASA:NYSE), Gold Fields (GFI:NYSE), Hecla Mining (HL:NYSE) and Richmont Mines (RIC:Amex)."
– This week’s Commitments of Traders report lends credence to Shartsis’ call for a bounce. The report shows that commercial traders (known as the "smart money") have been rapidly reducing their bearish bets against gold. "The just-released report," says Shartsis, "shows a big shift…as the commercials decreased their shorts by a very big 40,892 contracts, while paring their long position by only 1,486 contracts. This is a pretty good move in the right direction for gold bulls."
– In other words, the smart money is becoming more favorably disposed toward the yellow metal, which should be a good thing. – Turning our attention back to the realm of paper assets, what should we make of our confused little stock market? For weeks it had been falling for no apparent reason. And now that it finally has a good reason – or two or three – it doesn’t. It inches higher.
– Throughout the spring months, the stock market seemed like a wax museum – lifelike, but fixed in place. As July arrived, however, the wax museum became a House of Horrors…the wax figures came to life and terrorized investors. Between June 30 and July 26, the Nasdaq tumbled more than 10%.
– But the horrors have ceased for the moment at least, as the Nasdaq has bounced back about 3%. And the lumps are now hoping that the House of Horrors becomes a kind of financial Louvre – a serene location filled with countless items of beauty and objets d’art…a place where the sights and delights are well worth the price of admission.
Bill Bonner, back in Albuquerque…
*** "There’s so much to see in New Mexico," Elizabeth commented.
There are two factions in our family. Elizabeth and Henry study things carefully and try to learn all they can. When they travel, they read guidebooks, history books and travel books – with the aim of learning every detail they can.
Elizabeth was studying an "insight Guide" to New Mexico on the plane. By the time we landed, she knew the history of the place – even its geological past – and was ready to visit museums and historical sites all over the state.
The rest of the family takes a more spontaneous approach to tourism. We get in the car and drive; we may not always end up where we intend to go, we say to ourselves, but we always end up where we ought to be.
"This is one of the most geologically active regions in the world," Elizabeth continued. "It has active volcanoes. Of course, the last eruption was 3,000 years ago."
In a matter of minutes, Elizabeth was lecturing the family on the Permian Sea…on the KT boundary…and volcanic rocks. "All igneous rocks are formed by volcanoes," she explained. "But some cool inside the earth – such as granite – and others cool after they get to the surface, such as…I think they’re called tuffs."
We stopped in at the Natural History Museum in Albuquerque. You walk through a display that begins with the Big Bang and carries along until Homo sapiens appear. Particularly impressive, and somewhat alarming, was the presentation on the great extinction. About 65 million years ago, most advanced forms of life on Earth were exterminated. No one knows exactly why. But the leading theory is that a giant burning rock, 6 miles across, smashed into the Gulf of Mexico. It set off floods, firestorms, and all manner of catastrophe. The big dinosaurs went down like duckpins. The pictures in the museum show them lying on their backs with their feet sticking up.
But the little mammals survived, flourished, and inherited the Earth. The meek little things had been hiding in holes to avoid the dominant, meat-eating beasts. They were saved by their own modesty, protected by their ignoble holes.
Man is now the world’s Tyrannosaurus rex…the alpha species…the cock of the earth’s walk. What meteor has our name on it, we wondered.
*** "What happened to the camels?" The question was posed to one of the student guides at the Natural History Museum. Elizabeth had noticed that camels disappeared from North America about the same time as humans arrived. She assumed they had been hunted to extinction.
"I think they just crossed the Bering Strait…at that time it was a land bridge into Asia," was the answer she got.
There are many different reasons the camels might have disappeared. The student seemed to have picked the least plausible of all: that the camels all decided to move to Siberia! What makes college graduates so dumb, we wondered again.
Looking at the course catalogs of modern universities, we think we have a clue. Lesbianism is a big subject in today’s universities. Lesbians in 18th Century English Poetry is a typical course offering. Or maybe A Lesbian Interpretation of the Class Struggle and Lesbos and the Classical Tradition…we have not yet seen Lesbianism and Nuclear Physics, but it is surely coming.
Forty years ago, colleges offered few courses on lesbianism. Still, many of them must have depressed students’ intelligence. We recall a class in which the professor tried to argue that political science was as much a science as chemistry. The idea is absurd, but you got credit if you were credulous enough to believe it. Another professor used his English literature class to convince students – especially the coeds – that they should practice free love. "Why should you treat one part of the body different from other parts?" he would ask. And there was a professor of philosophy who didn’t believe in learning at all. He would come to class and tell us all to be quiet and meditate. "Don’t think," said he, "just be." This might have been good advice…but not the sort you’d want to pay for.
*** We had intended to drive across the country. We wanted to show the children the whole place…including the vast cornfields in the center of the country, the part between the coasts…the part commonly called "’flyover country." But we dallied too long on the East Coast and decided to fly over it. Yesterday, we took a plane in Charlottesville and few to Albuquerque.
*** We had been driving around in a Mercury minivan. But it was too small for our family of six. Here in Albuquerque, we switched to a Ford Expedition, a heartier vehicle with surprisingly little space for luggage.
*** "The pension crisis of the world’s richest nations is like prostate cancer – evolving so slowly that it’s likely to be ignored until it approaches an excruciatingly painful climax," writes old friend, Martin Spring. "Victims ignore early signs of the problem, frightened by the prospect of the unpleasantness of the treatments required. Yet the longer they delay, the more painful and dangerous the condition will become.
"Future pensions are going to be much less attractive than the current generation of retirees enjoy and the next generations expect. Funding them is going to become a major burden on taxpayers, businesses, employees and investors. And along the way there are going to be some painful accidents."
The black hole in U.K. public-sector schemes alone has been estimated at the equivalent of more than $850 billion, and the cost of additional contributions to close the gap at $57 billion a year. Generating that sort of money would require massive tax rises and savage cuts in public services. The politicians prefer to ignore the problem (although they’ve made sure that their own pension scheme is both lavish and secure).
The evolving pensions crisis is not limited to Britain:
In the United States, corporate pension funds have seriously underprovided for their liabilities – airline funds alone are $280 billion in deficit. To try to make up the shortfalls, employers are having to contribute more – the "legacy costs" of past retirement promises (pensions and medical care insurance) have become a major burden for industries such as steel, airlines and automobiles. For example, they account for $1,900 of the costs of every car sold by General Motors.
The federal bailout fund is already in the red, yet there’s worse to come as companies seek to dump their pension obligations on the fund. Retirees suffer, too. When the fund took over U.S. Airways’ liabilities recently, its pensioners faced cuts of up to 50 per cent in benefits. [Ed. Note: The pensions crisis is but one spoke in the wheel of this rapidly approaching Federal disaster. We urge you to learn more:
In Europe, where retirees depend on state pensions rather than company funds, experts warn that benefits may have to be cut by up to a third to keep the system solvent.
In Japan, pension fund assets of the 100 largest companies cover less than half the amount of their promises to retirees. In the year to March 2003, pensions-related write-offs were equivalent to a massive 72% of their pre- tax corporate profits."