The important news:
Yesterday, both the Bank of England and the European Central Bank announced moves to boost the economy. They’re both falling in line behind Mr. Bernanke, who is “pulling out all the stops” in order to avoid a deep depression. Both the BoE and the ECB are going to take up forms of QE – quantitative easing – in which the banks buy government debt directly.
Don’t try QE at home, dear reader; you’ll be arrested for counterfeiting. QE so closely resembles old-fashioned printing press money that you couldn’t tell them apart in a police line up. Both are ways to increase the supply of money…which, according to theory, leads to consumer price inflation.
The Dow fell 102 points yesterday too. The bear market rally has gone on for nearly 9 weeks. It’s probably ready for a rest…and maybe a pullback. We doubt it’s over though. There is still far too much money and far too many suckers who have not been pulled back into the stock market. The next leg down of this bear market will have to wait – most likely.
Another ominous thing that happened yesterday was that bond yields increased. The yield on the 10-year Treasury note – at 3.3% – is more than a full percent above its low. The yield on the 30-year bond is at 4.26%.
These yields are still very low. But they seem to be moving higher. They are ominous because at some point in the future we expect all Hell to break loose in the bond market. The slippage we’re seeing now in bond prices (when prices go down, yields go up) may or may not be an early warning.
But we probably have a few new readers of The Daily Reckoning…let us backtrack in order to bring them into the picture.
We begin by going back half a century. America emerged the world’s biggest, strongest, most innovative and dynamic economy after WWII. Then, it went from strength to strength…to weakness. Gradually, Americans turned their attention away from production and towards consumption. And gradually, America’s most profitable businesses shifted from making things to financing them. That’s why GM created GMAC…and why GE staked its future on GE Finance. And it’s why the center of American economic power moved from the manufacturing hinterlands of Detroit and Cleveland…to the financial centers on the coast…notably the big one in Lower Manhattan.
The financial sector boomed by supplying credit. Americans borrowed. And so, their debt increased. From being the world’s leading creditors in the ’50s and ’60s…they became the world’s leading debtors in the ’80s and ’90s. Gradually, the consumer economy required more and more debt to produce an extra unit of output. Debtors had to borrow not only to buy…but also to pay back, or pay the interest on, previous borrowings.
In the Eisenhower years, it took only an extra $1.50 or so of debt to spur an extra dollar’s worth of GDP. By the end of the century, the cost had risen to over $4…and then to $6 a few years later. Total debt, which had been about 150% of GDP before Ronald Reagan took office, shot up to 370% in the final years of G.W. Bush.
By the late ’90s and early 21st century, the American economy had entered the Bubble Epoque. The financial industry – aided and abetted by the Fed – was providing so much ‘liquidity’ it was causing asset prices to bubble up everywhere. Of course, bubbles always blow up – without exception. And when the dot.com bubble exploded in 2000, at first, we thought that was the end of the Bubble Era. Little did we realize, the biggest bubbles were still to come. Then came the bubbles in housing, art, emerging markets, oil, and commodities. All blew up. But the biggest bubble of all – the bubble in credit – blew up too, bringing the Bubble Epoque to a close. Capitalism giveth. Capitalism taketh away. The process of what Schumpeter called “creative destruction” continues.
We are now in the post-bubble era. The financial industry has been bombed out. It can no longer create bubbles. Governments all over the world are propping up the walls…and shoring up the foundations. But the Bubble Epoque can’t be revived.
Is that the end of the story? Not at all. The feds’ efforts to stop the progress of capitalism will have some spectacular consequences. The fireworks will start when the bond market cracks…sending yields through the roof. And that’s all we have to say about it today…stay tuned.
One of the reasons people believe the “worst is behind us” is because the Chinese economy seems to be growing.
This from the Financial Times:
“Perhaps more than any major economy, China is showing signs of improvement, writes Geoff Dyer. Indicators suggest that the economy began to recover in March with industrial production rising 8.3 per cent from 2.8 per cent in January-February.
“But could it all be a bit of false hope? Could we, in fact, be misinterpreting a temporary stimulus-induced economic pick-me-up as an actual sustainable recovery?”
China says it is growing. But if it were really growing it would be using more fuel and more electricity. Instead, industrial demand for gasoil, used by factories and commercial plants, fell 12.6% in the first quarter.
Our old friend Sean Corrigan, chief investment strategist over at Diapason Commodities, also points out that electricity generation has been going down too. The last seven months’ power output has been 8.5% below that of a year ago.
Another old friend, Jim Rogers, believes China – along with commodities – is still the best place for your money. He may be right. But we don’t speak Chinese…and we fear the Chinese market may be subject to more risks than is popularly understood.
One of the risks we think is especially understated for China is the risk of central planning. Investors tend to favor China – over, say, India – because they think the Chinese government – even in the hands of communists – is capable of guiding the economy to prosperity. That is, in China’s case, they believe central planning is a plus and pay a premium for it. But central planning is always a mistake as near as we can tell. It is only not a problem when it is carried out so clumsily that it is ineffective.
“China’s head honchos tout a rosier future for the ‘Red Dragon’ economy than seems possible,” says The Richebächer Letter’s Rob Parenteau. “Over 15,000 factories in the Chinese provinces of Shenzhen, Guangzhou, or Dongguan have already shut down… with many more slated to close over the months ahead.
“It’s an epidemic that’s happening all across Asia, though you might not be hearing about the full scale of their meltdown on the evening news.
‘Half of China’s toy factories have shut down. In fact, at least 67,000 factories overall closed in the last six months of 2008. With another 60,000 factories in the Wen Zhou Province alone about to shut down.
“As many as 27 million Chinese are already out of work – with 20 million of them streaming out of the cities and back to the abandoned farms of the Chinese countryside.”
Remember the 1980s? Then, too, investors were willing to pay a premium for central planning. Then, it was Japan that was doing the planning. Investors sold U.S. stocks – on the theory that the United States couldn’t get its act together – and bought Japanese stocks, because MITI, the Japanese bureaucracy in charge of economic planning, was supposed to be doing such a fine job of guiding the country to eternal success. It didn’t seem to bother them that this same agency had advised Japanese carmakers to stay at home and not try to penetrate the U.S. auto market.
Of course, in 1989, the Japanese market…and its economy…cracked. Then, the Japanese turned their central planning skills to the task of avoiding the kind of creative destruction that capitalism had in store for them. In this they were more successful – preventing the necessary restructuring for the next 20 years. Brain dead banks were kept alive. Zombie companies remained in business. And an amount of money equal to more than an entire year’s total output of all the Japanese people was spent in futile ‘stimulus’ efforts. Today, Japanese stocks are still selling for 75% less than they were in 1989. Japanese property, too, is only worth about a quarter of what it was worth at the top of the boom.