Everyone involved in the financial world has been speculating on what is in store for the New Year…will the dollar rally vs. the euro? And when will the housing bubble burst? Gary Shilling gives us his insights…
My economic, financial and political outlooks have spawned six investment themes for this year. Three are likely to happen, while the other three are in the "maybe" category-they’ll probably unfold at some point, but their timing is less clear.
First, a rally in the dollar is likely, especially vs. the euro.
The rationale for the weak dollar is the growing trade and current account deficits. The fear is that foreigners will soon no longer be willing to hold the dollars generated by these deficits and invest them in U.S. assets, so the buck’s decline is anticipating its collapse. Indeed, Indian, Russian and some other central banks say they are thinking about reducing their dollar shares in favor of the euro.
Nevertheless, most foreign countries depend on exports that directly or indirectly go to the U.S. Also, keep in mind that foreigners are selling and Americans are buying their goods, and in a world of excess supply, the buyer is king.
There are good fundamental reasons for the dollar to strengthen. The United States is the world’s growth leader, which should benefit her currency. In addition, America lacks the language barriers, labor immobility and productivity-robbing socialistic tendencies that hinder Euroland economies. With these forces and consumer malaise, the outlook for economic growth in Euroland in 2005 and beyond is bleak. And with slow growth, interest rates there are lower than in the United States, which should attract money to America.
Longer run, America’s commanding lead in new tech should ensure the buck’s dominance for at least a decade. Historically, the country with the fastest productivity growth had the strongest currency.
2005 Economic Forecast: Deflation Expectations
Secondly, consumer deflationary expectations will spread:
When deflation is widely accepted, buyers anticipate it by waiting for lower prices before buying. This creates excess inventories and idle productive capacity, forcing sellers to cut prices in order to move goods and services. These cuts, in turn, confirm buyer suspicions, so they wait even further for even-lower prices and, in the process, generate a self-feeding deflationary cycle.
This is already evident in autos. In Oct. 2001, GM introduced loans with zero down, zero interest rates and zero payments for six months or a year, in response to 9/11. The result was an explosion of vehicle sales during that month, as consumers left their barricaded homes and stampeded into auto showrooms. But they got accustomed to big incentives quickly, so GM and other auto companies have had to keep increasing them in order to move the metal.
This last Christmas season showed that consumer deflationary expectations have spread from autos to general merchandise, especially Christmas gifts, as Wal-Mart saw when it decided not to offer giveaway prices on Black Friday, the all-important shopping day after Thanksgiving. When customers simply trotted over to the competition, leaving Wal-Mart with lousy start-of-the-season sales, the giant retailer had to chop prices to catch up.
Airlines also face consumer deflationary expectations as online ticket sales make it easy for consumers to find the lowest fare, and fares continue to fall. Telecom is another example. Intensifying competition among land-based telephone service, cell phone, cable, satellite, and now wireless is slashing prices and encouraging consumers to sign short contracts in anticipation of lower prices.
One can argue that falling real wages among lower-income households are the mainstay of this ruthless search for low prices. True in part, but as noted in the case of autos, and also valid in airfares and telecom, a pattern of price declines spawns deflationary expectations that spread to almost all income classes.
2005 Economic Forecast: Yield Curve Likely To Keep Flattening
Another point to make is that the yield curve will probably continue to flatten:
The Treasury yield curve has flattened since the Fed started raising the short-term rates it controls last June. There’s not much question that the Fed plans to continue its rate-raising campaign, which started when Federal funds was at 1% and at the current 2.5% target is still considered by the Fed to be below equilibrium.
How far is the flattening yield curve likely to go this time? Will it go all the way to inversion with short rates above long rates? It didn’t invert in the low inflation run-ups to the 1953-54, 1957-58, 1960-61 and, in essence, the 1990-91 recessions, but it did invert ahead of recessions in the high inflation days-1969-70, 1973-75, 1980 and 1981-82.
The yield curve also inverted ahead of the 2001 recession, and that was definitely not an era of high and rising inflation. But the federal budget was in surplus then, and that may have convinced bondholders to accept lower yields than during the days of deficits. In any event, that surplus is history, at least for now, and in this era of low and, I believe, declining inflation, I look for a further flattening, but not an inversion of the yield curve in the quarters ahead. If I’m wrong and the yield curve does invert, look for a recession. That’s always been the case in the post-World War II years. No exceptions.
Even without an inverted yield curve, the effects of the spread between interest rates on 2- and 10-year Treasuries moving toward zero will be considerable. It certainly would ruin the part of the carry trade that concentrates on borrowing short term and investing in long-dated Treasuries. And it’s clear that the Fed is not happy with this carry trade anyway.
A flat yield curve would damage many less speculative investments. Financial stocks have done well in recent years and the earnings of those in the S&P 500 index account for about 40% of the total. This isn’t surprising since, at heart, many financial institutions are spread lenders, borrowing short term and lending long term. The steep yield curve in recent years has been their bread and butter. Further flattening in the Treasury yield curve would compress these spreads-and the earnings of financial institutions-considerably.
2005 Economic Forecast: The Housing Bubble Breaks . . . Maybe
And to start on the "maybe" section…maybe the housing bubble will break this year:
I’ve warned about the expanding bubble in housing prices in recent years, and continue to forecast its burst. Prices, which normally rise in step with incomes and the CPI, have run well ahead in recent years. What might trigger a nosedive in American house prices?
I can see four triggers. The first would be a spike in mortgage rates, reversing their long and housing-friendly decline. A second pin that could prick the house bubble is loss of confidence in mortgage-backed securities in addition to faith in the obligations of government-sponsored housing enterprises. This could result from the ongoing investigations of Fannie Mae’s accounting. Fannie dominates that market, and the fixed-income instruments it backs have become very important components in the portfolios of many financial institutions. Third, the housing bubble could end if the low-end, first-time homebuyers lost their jobs and consequently were frozen out of the market. Then their plight would ripple up the move-up market, as those planning to buy more expensive houses couldn’t sell their existing abodes at their hoped-for prices. Finally, leaping house prices might reach the point that they simply fall of their own weight.
A significant nationwide fall in housing prices, the first since the 1930s, would wipe out the slender equity of many homeowners and cause much more national distress than the big 2000-2002 bear market in stocks. As a result, widespread or chronic house price weakness would almost certainly end the 20-year U.S. consumer borrowing and spending binge and touch off a frantic saving spree.
A residential real estate collapse and a saving spree in this country, combined with its echoes and other negative economic consequences abroad, could create a big enough global financial and economic crisis to convert the good deflation of excess supply I foresee to the bad deflation of deficient demand.
for The Daily Reckoning
February 15, 2005 — Paris, France
As Mr. Shilling points out above, a collapse in the housing market is inevitable…all the triggers are there, and the dominoes have already begun to fall in this real estate market crash.
Dr. Gary Shilling is president of A. Gary Shilling & Co. Inc., an investment advisory and economic consulting firm and publisher of the monthly INSIGHT newsletter.
A regular columnist for Forbes magazine, Gary Shilling appears frequently on radio and television business shows and has written six books, including Is Inflation Ending? Are You Ready? in 1983 and, more recently, two books detailing his forecast for the new world order and its consequences for your wallet.
Analysts are rubbing their eyes. They had been told that the Bush administration was getting serious about cutting the twin deficits – current account and federal. But when they look at the budget proposals, they see no sharp objects. How will any cutting be done? What will be cut? When? How?
Not getting satisfactory answers, speculators are beginning to sell off the dollar. After a month or so of rally, the dollar looks vulnerable again. Yesterday, the euro edged back up to $1.29. Gold rose impressively too – adding $5.30, to bring the price over our $425 buying target.
The European Central bank lost $625 million because of the falling dollar in 2003. In 2004, the loss rose to $1.3 billion. As a reserve currency, the dollar has been incompetent. Yet, it is still in safes and mattresses all over the world. The Japanese Central Bank alone has $715 billion. And poor Mr. Asakawa! He’s the one in charge of Japan’s foreign-currency assets. The man sleeps with a little device next to his bed. If the dollar falls below a certain level, an alarm goes off. Mr. Asakawa has been sleeping soundly since Christmas – when the dollar began a rebound. But now, it looks like he may be in for more sleepless nights. How he must wish that he had fewer dollars to worry about!
What should you be doing with your dollars now, dear reader?
Playing it safe…
Stocks have been rallying since last October. That rally could end at any time…and might be ending now. When the upward momentum on this plane runs out, passengers will find a lot more downside that upside. That is, at these levels stocks have much more room to fall than room to rise.
Bonds we’re less sure about. Our guess is the economy is softening…and that a slump is unavoidable. People are going to want and need cash, and the sure returns of Treasury bonds (not junk bonds).
On the other hand, the dollar is extremely vulnerable. Buffett and Gates are betting against it, and they’re probably right. Which is why you don’t want to leave too much money in U.S. assets of any sort, including U.S. Treasury bonds.
The safest investment to hold is gold. The world economy – and most assets – are threatened by humbug, pretension and lies. Investors are flattered, seduced…and lured to their own ruin by them. They have been told that they can get rich – without working or saving. Their houses are rising in price; they think that is all they need.
Gold’s great virtue is its indifference to humbug. In an honest economy, you wouldn’t need it. But in an honest economy, you’d probably have it already.
An ounce of gold was only $288 when we declared our Trade of the Decade at the beginning of the 21st century. "Sell the Dow, Buy Gold," was our advice. Now, if you want to buy an ounce, it will cost $427. Not a spectacular return, but a healthy one. And the decade is only half over.
More news, from our team at The Rude Awakening:
Eric Fry, reporting from Wall Street…
"General Motors and Russia have – since last month – the same credit rating. This is quite amazing. GM, the former perfect credit, is careening toward junk status while Russia is on its way into the ‘all-stars’. Can Russia cut the mustard?"
Bill Bonner, with more opinions:
*** "I don’t know what [New York Times columnist Thomas L.) Friedman is thinking," Elizabeth commented last night. We had gone out to dinner on Valentine’s Day. But we spoke not of love, but of money: "Falling oil revenues might or might not cause changes in Iran," she continued, "but whether they would be good changes or bad ones is impossible to say."
We thought again about the grandiose fantasy holds up Friedman’s whole oeuvre, not to rigorous analysis, but to ridicule. It took our breath away. He cannot tell you whether the price of oil will go up tomorrow or down. But somehow he thinks he knows that if free parking places were made available to American drivers of "hybrid" cars, not only would the price of oil be lower in the future, but that the consequences of a lower oil price would be salutary for governments on the other side of the globe. That is, he thinks he can see not only his own future…but also, apparently, everyone’s. Not a sparrow can fall from a tree, in Georgia or the Hindu Kush, but that Friedman can see it coming. We think we will ask him to tell us where we will die, so we can avoid the place.
But that is the indiscreet charm of the world improvers – they are dreamy jackasses.
Just as ignorance increases by the square of the distance from a given event…so are the odds that things won’t work out the way you expect multiplied by the squares of each intervening event. Between a proclamation of free parking for hybrid drivers and the kind of "reform" in Iran that Friedman wants to see are a number of intervening events: people have to drive a lot of hybrid cars (enough to slacken oil sales); demand for oil actually has to go down (someone has to tell the rising middle classes in India, China and the rest of the world to turn down the air conditioning); the price of oil actually has to fall (note to the feds: stop undermining the dollar…note to oil producers: keep pumping more oil, even if demand falls); Iran actually has to make less money from its oil exports (another note to Iran: pump more…but make sure you don’t make more money from it); Iran actually has to be pressured to do something because of the lower oil revenues; and last, of all the things that might or might not happen as a result of lower oil revenues, Iran must undertake a program of "reform" that would suit Mr. Friedman (we do not even consider whether or not it would suit anyone else…or whether or not it would increase the sum of human happiness in the world).
Each of these events is, at best, a 50/50 proposition. Actually, we rate the likelihood of a fall in oil prices as a consequence of free parking for hybrids at zero…but for the purpose of this little exercise, we will spot the columnist a few points and simplify the math. So, even if the odds of each event were one in two, the odds of the whole chain of events working out as expected could be expressed as .5 x .5 x .5 x .5 x .5 x .5. We’re on the train and not going to do the math…but what it amounts to is this: Icebergs will float in Hell before free parking spaces for hybrids bring desirable "reform" to Iran.
"Well," you may say, "of course, free parking won’t do the job alone, but at least it’s a step in the right direction."
But how does anyone know it is the right direction? Who knows what direction the world is going…and whether it is right or wrong? If high oil revenues lead to wicked government, why is Texas no less wicked today than it was in its peak oil-exporting era 40 years ago? The United Kingdom realized huge revenues from its North Sea rigs – during the Thatcher years. We do not recall the country was in need of regime change as a result. An oil exporter that might benefit from regime change, on the other hand, is Venezuela. But its government was duly elected and thus under the heel of the majority, just as Friedman would want it.
On the other hand, just as high oil revenues don’t always lead to wickedness, the lack of them doesn’t guarantee virtue. We don’t notice that North Korea has reformed itself. Nor China. Nor Zimbabwe. Germany in the ’40s was not known for oil revenue or enlightened government. Nor was Italy. And if you go back more than a century, you won’t find a single example of a people that were driven bad by petroleum revenues nor who were redeemed by cheap oil. It was not high oil incomes that led Caesar to cross the Rubicon…nor that brought the Huns to terrorize Europe…nor that lured the Mongols into India. More recently, we don’t recall newsworthy reforms in Iran – even when oil revenues declined sharply in the 1980s. As we remember it, the price of oil dropped 75%. If falling oil revenues lead directly to "reform" you’d think that every oil exporter in the world would have reformed itself under that kind of pressure. Of course, if they had…Friedman would see nothing to reform now.
Sin and wickedness has been with us for much longer than the internal combustion engine. We doubt that they would disappear, even if they the price of oil were to go to zero.
But the little lies, empty humbugs, misapprehensions and "harmless" proposals are piled one on top of another…until a vast pyramid is built…an edifice is so grand no one can miss it. Later generations will wonder: What was the point? But at the time of construction, no better use could be found for time and money; no other public spectacle upstaged it.
And who today can say that Friedman is wrong? Who can say for sure that parking a hybrid for free in a downtown lot in Des Moines won’t be the "tipping point" event that causes a collapse in oil prices…the little butterfly that flaps its wings and sets in motion a whole chain of airy events…leading to a tornado in downtown Tehran? Finally, suddenly, a new wind could blow through the Persian capital…and the mullahs see their turbans take flight!
Could be, but we would not sell our oil stocks in anticipation.
Oil, and all other commodity prices, for that matter, have hit their highest point in 20 years, and our Resource Trader Alert editor, Kevin Kerr, says that the opportunity to profit from commodities is enormous.
*** A letter from one of our readers:
"On Tuesday, February 08, 2005 04:58 pm, you wrote:
> We add an additional preface: we note that the mail we
> receive from readers is running 10 to 1 against us,
> following last Friday’s meditation on Mr. Bush as an
> evangelical democrat.
"In a hope to make the mail more along the lines of "10 in 1 FOR us", I say you’re dead on in your assessment of Bush and his World Improver actions!
"Just think how much better our schools, our environment, and our overall standard of living would be if the hundreds of billions of dollars spent on killing people in Iraq were spent at home.
"Keep up the original thinking. It’s something MOST Americans are not used to, and are deathly afraid of. (I therefore think the tide will not turn in your ‘hate mail ratio,’ unfortunately.)"
*** Here, a letter from a longtime Daily Reckoning sufferer:
"Dear Bill, I address you as Bill, as I would an old friend, because in my eyes that is what you have come to be as I have read and enjoyed your messages. I doubt if I have missed a single one of them for the many years that I have been fortunate enough to receive them.
"Anyway, all accolades aside for the moment, regarding the 10:1 ratio of mail against what you have to say, it certainly seems appropriate to this observer. Not, I hasten to add, because you are in any way in error in your astute observations, but rather that those 90 plus percent of the letter writers clearly reflect the current abysmal state of affairs of the average American’s mental state.
"By way of expanding on that, it really doesn’t take a rocket scientist to see what the American way of government has evolved into over the past century. That a small percentage, perhaps one tenth of one percent of the total population, produces one hundred percent of this country’s
leaders is obviously lost on the hoi polloi – who in accordance with the quality of their written words deserve that designation.
"Further, that small percentage of the American ruling class is also what can accurately be said to be, the owner-class. Now that group of people, not content to be just filthy rich, also want to be all powerful. To wit, from that class arises the American rich-man power-junkie. These people populate all, or most all, of the front seats in our government, and they certainly don’t run the business of American government for the benefit of that same hoi polloi that, in truth can’t see the woods for the trees.
"Anyway, Bill, as you might suspect, I’m a little long in the tooth, but thankfully have retained some modicum of thinking powers. (My mis-spent youth took place during the Great Depression, and it’s hard to believe I would live to see it happen again) Therefore, looking past the late stages of degeneration of the so-called American-way, I know, as I’m sure you do, it’s always advisable to keep a robust sense of humor. As you have often said, obviously to a lot of deaf ears, investors often don’t get what they want, but most often get what they deserve. It seems to me, given the hubris of the 90 percent-responders that goes for the people as well.
"Thanks for all the wonderful articles. I forward many of them to those who appreciate them."