THE BEAR'S LAIR Where’s the juiciest bear food? By Martin Hutchinson
In the spirit of the endless year-end speculations about developments in 2008,
I thought it worth looking at which markets - debt, equity, commodities or real
estate - were most overvalued in December 2007 and hence could be expected to
provide the best ''bear food'' for the year ahead. After all, for us bears
picking losers is much more enjoyable than picking winners!
Overall, 2008 looks to be a good year for bears. The US Federal Reserve has
been walking a tightrope since August between the precipices of a collapsing
financial system and resurgent inflation. With a 3.2% November Producer Price
Index rise (7.2% over the previous year) announced on Thursday and a 0.8%
Consumer
Price Index rise (4.3% over the previous year) announced on Friday, it can now
be officially confirmed that the tightrope has vanished into thin air. The
United States over the next 12 months will experience both a collapse in its
financial sector and a violent resurgence in inflation, and there’s nothing
whatever the Fed can do about it, no interest rate trajectory that will not
worsen one problem more than it alleviates the other.
If the Fed lowers interest rates further to bail out Wall Street, it will
worsen inflation. Oil prices moved from US$70 to $90 on the 0.75% drop in the
Federal Funds rate from 5.25% to 4.50% so will surely soar to around $120 if
the Fed is foolish enough to lower it to 3%, as several Wall Street and
permabull commentators are calling for. Equally, if the Fed were to raise
rates, even gently, in order to contain resurgent inflation, the US stock
market would tank and the housing finance market would suffer yet further
losses, as housing ''affordability'' diminishes as interest rates rise.
The right stance would be a significantly higher level of rates, perhaps in the
6.5%-7% range, which would be fairly close to neutral on inflation, but that
would devastate stocks and housing - both necessary declines, but the Fed’s
number one objective is not to be blamed for such events. Most likely, the Fed
will be frozen into immobility, keeping interest rates at or near their current
levels, in which case both inflation and the housing crisis will steadily
worsen, while stocks decline.
The US stock market, after more than a decade of excessive and unjustified
optimism, seems destined to crash several thousand points onto the rocks below.
The only question is the timing. Should the Bureau of Economic Analysis massage
the next few months’ inflation numbers successfully, and the Fed continues to
lower interest rates, it is possible that the housing decline will slow, fed as
it will be by an ocean of liquidity, so that at least in the first half of 2008
optimism will once again reign. However it seems unlikely that any false dawn
of this type will last long; the collapse of the securitization mechanism, and
the withdrawal of confidence from asset backed commercial paper vehicles, make
it unlikely that the credit bubble can be sustained for much longer - bank
balance sheets are simply not large enough to absorb all the necessary paper.
At this point, the election comes into play. The Democrat candidate will
undoubtedly be relatively protectionist, so the Republican will be forced to
move towards protectionism in order to deflect Democrat attacks on a highly
flawed Bush administration economic record. Consequently, whoever wins in
November 2008 will have made pledges on trade that he or she will find it
difficult to ignore. Not only is the Doha round dead therefore, but without the
United States somewhere close to acting as free-trade cheerleader, the world
seems likely to move into an era of beggar-my-neighbor protectionism similar to
the early 1930s, although one hopes less intense than that unhappy period.
Globalization will go into reverse.
The brunt of the cost will be borne, not by India and China, whose economies
will remain highly competitive, but by Western consumers, who will find their
jobs disappearing as output declines and their living standards suffering as
persistent inflation is no longer alleviated by an endless flow of ever-cheaper
manufacturing and services from emerging markets.
Gold dust
Outside the United States, it seems likely that the commodities boom or bubble
will continue, at least for the first few months of the year. The merits of
oil, gold and other commodities as inflation hedges will increasingly recommend
them to the huge money pools of hedge funds and sovereign wealth funds. Gold in
particular is likely to see quite a spurt - maybe heading towards the $1,500
level. Later in the year, the commodity boom will collapse, but over the year
as a whole it seems unlikely that commodity prices will greatly decline.
Given the Fed’s dilemma, long-term bonds must be about the most dangerous of
current investments (low-quality bonds being even more dangerous than
Treasuries, as liquidity tightens further). Rising inflation will weaken their
appeal as a safe haven (even index-linked Treasuries will suffer as investors
begin to suspect that published inflation figures are massaged) while the
tightening liquidity and increasing US budget deficit in a period of US
slowdown will tend to drive yields higher. The Fed will be able to do nothing
about this; if it reduces short-term rates, inflation will drive up long-term
rates, while if it increases short-term rates to combat inflation the entire
yield curve will move higher as rate expectations alter.
Housing and other real estate assets may see a modest bounce in value, or at
least a slower decline, in the early part of the year as the Fed and other
central banks continue trying to stimulate the world economy, producing mostly
inflation. The various bailout schemes proposed by politicians will also
increase confidence somewhat. Eventually however, as the market comes to
realize that the US housing finance market as we have known it for 30 years is
dead, the house price decline will continue and indeed intensify.
Outside the United States, continental western European economies seem likely
to have a quiet, albeit somewhat negative year. They do not have real estate
bubbles in the process of bursting; indeed German house prices are lower than
they were 10 years ago. German mortgage banks would be thus in fine shape - if
they had not foolishly speculated in the more ''developed'' market of US
mortgages.
Eastern Europe is a different matter. Too many of these economies have been
borrowing internationally to finance their domestic real estate and consumption
booms. While the overall trend for these economies to catch up with western
Europe seems likely to continue, balance of payments deficits in the likes of
Estonia and Latvia of more than 10% of GDP are likely to prove extremely
difficult to finance as international cross-border investment declines into a
recession. With liquidity high in the early months of 2008, their recession may
be delayed into 2009, but recession there will be.
The one exception to the moderate optimism for western Europe is Britain, which
seems likely to have a very tough year indeed. The financial services business
must inevitably suffer a very poor year, and these days that business forms a
very high percentage of the London economy, if not of the British economy as a
whole. Further, London house prices are overvalued by at least 200% at the high
end of the market and have not yet begun to drop. Unlike in the United States,
where the first half of 2008 may see a temporary let-up in the house price
decline, in London house prices will drop increasingly swiftly, with the total
top to bottom drop of as much as 40-50% over the next few years.
Since most middle-class Britons foolishly have their wealth largely tied up in
housing, this will have a very severe negative wealth effect on consumer
spending. Add in the fact that the profligate Blair/Brown government has
increased public spending by more than 5% of GDP during its decade in office,
producing a public sector deficit of more than 3% of GDP at the very top of an
unsustainable boom, and you have the recipe for the worst downturn in Britain
since 1980-82. This time, however the pain will be concentrated not in the
manufacturing North of England but in overpriced service-oriented London and on
the successful over-leveraged yuppies who have rendered that city uninhabitable
for those of middle incomes. About the only saving grace for the British
economy will be a collapse in the value of the pound against the euro as it
resumes its long-term purchasing power parity of $1.50 against the dollar.
In Asia, the principal loser will be China, which is already suffering from
tighter credit conditions in the domestic market. Rapid Chinese growth has
finally sparked off consumption, while inflation is rising fairly rapidly and
real interest rates in the domestic economy remain heavily negative. At some
point, Chinese domestic savings in the banking system will prove insufficient
to finance both consumption and the continuing needs of loss-making state owned
entities. China can solve its domestic banks’ bad debt problems by using its
foreign exchange reserves - indeed it is already doing so - but that is bound
to lead to further inflation, possibly tending towards hyperinflation.
It seems likely that China will in 2008 enter something like the US Great
Depression, albeit with high inflation rather than deflation, with an eventual
drop in GDP of 20% or so and in the Chinese stock market of 75-90%. That will
be extremely painful for Chinese domestic investors and for those foreign
investors who have been sucked into this highly speculative market, but like
everything in China it is likely to take place quickly, so that in five to six
years time China will once again be enjoying its rapid climb up the league
tables of relative and absolute economic prosperity.
India wobble
India is more difficult to read. On the negative side, Indian public spending
is increasing far too rapidly, tending to crowd out more productive sectors of
the economy, while rising inflation and a bubbly stock market both suggest a
downturn is near. Further, the Indian political situation is unstable, with a
leftist government led by an aging moderate facing elections in 2009. That
seems almost certain to lead to a further bout of wasteful public spending. On
the positive side, the Indian economic sectors that have liberated themselves
from the dead hand of the ''permit Raj'' are not going away anytime soon and
seem likely to continue taking market share from their overstuffed Western
competitors. On balance therefore, I would see a wobbling beginning to an
Indian downturn, with inflation reaching double digits and the government
resorting to dubious price control schemes to control its reported level.
Further developments will await the election due in spring 2009, about which it
is still too early to prognosticate.
The most positive economic picture will be in those countries of East Asia that
have remained rather unfashionable since the Japanese bubble burst in 1990 and
the East Asian economies crashed in 1997. Japan itself seems likely to continue
its steady if unspectacular growth, with the growth rate accelerating if fiscal
policy remains tight for 2008, the current government remains in power and
interest rates are increased from their current 0.5% to a more normal level of
around 2-2.5% (Japan being such a savings culture, moderately higher interest
rates tend to stimulate rather than depress the economy.)
Taiwan too should do well - as an economy it is extremely liquid and, unlike in
2000, the technology sector is not the focus of the currently impending
downturn. However the most likely stock market winner in 2008 is South Korea,
currently selling on a price-earnings ratio of only 12. Presidential elections
this week and congressional elections in April will probably remove the fairly
anti-business government that has hampered the country's growth since 2003 and
replace it with the vibrantly pro-business Grand National Party.
So there you have it. Best bear opportunities: London real estate, long-term US
bonds and Chinese stocks. Best bull opportunity (not that we bears care much
about that): South Korea. Overall, a satisfactorily bearish year, darkening
further in its second half.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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