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So You Think 2008 Was Bad? Welcome to 2009
January 2009
MARKETSAT A GLANCE
Eric Sprott Sasha Solunac
Sprott Asset Management
Royal Bank PlazaSouth Tower200 Bay StreetSuite 2700, P.O Box 27Toronto, OntarioM5J 2J1T: 416 943 6707F: 416 362 4928Toll Free: 888 362 7172
www.sprott.com
Welcome to 2009. By all accounts thus far, it’s already been a pretty bad year… andwe’re only three weeks into it! If you will recall, 2008 was a pretty bad year for thebanking sector. For example, the shares of Citigroup, Bank of America, and the RoyalBank of Scotland fell 77%, 66%, and 92%, respectively, in 2008. So far this year(remember, this is only three weeks) the same stocks are already down 50%, 55%, and74%, respectively. Like we said, 2009 has already been a pretty bad year! For as badas 2008 was, 2009 promises to be a whole lot worse. The problem isn’t just the bankingsystem anymore. The problem is the banking system
and everything else
. This year, thefinancial crisis of yesteryear is morphing into an altogether different animal. It’smorphing into a financial crisis that has an economic crisis layered on top of it. In fact, tocall the current environment an economic crisis is likely understating the situation. Whatwe really have is a
global economic catastrophe
. One where weakness only begetsmore weakness, causing a vicious circle that is proving nigh impossible to reverse inspite of all the world’s financial, economic, and political brain trust throwing everythingthey have, including the kitchen sink, at the problem.In our last article, “Surviving the Depression”, we mentioned how the world is witnessingdepression-sized declines in economic activity. We mentioned how auto sales in the USwere down almost 40%. How housing starts were down almost 50%. How industrialproduction is falling off a cliff, with each month worse than the last. How jobless claimsare at multi-decade highs. How consumer confidence is at multi-decade lows. How thecompany surveys we follow are showing dramatic declines across the board ineconomic activity. We challenged the idea that this is a run-of-the-mill, minus-low-single-digit recession and we characterized this Depression (there is no other way to describeit) as “global, pervasive, and deep”.In the month since we wrote that article, the data points have only gotten worse, andthey will likely have gotten worse still by the time you read this article. US housing startsfell a further 15.5% in December to 550,000, the lowest on record. US industrialproduction fell a further 2.2% in December, to a 7.8% year-over-year decline. If youthink that’s shocking try this on for size: European industrial orders (a leading indicatorof industrial production) are
down 26%
year-over-year, the largest decline on record. Orhow about Japanese exports plunging
35%
in December – shocking, isn’t it? Globalsteel production was reported to be down 24% in December. All over the world,dramatic rates of decline in economic activity are being reported. The most disturbingdevelopments have been in employment, which took a marked turn for the worse thusfar this year. US jobless claims are now running almost 600,000 per week. You don’twant to annualize that number, but you may have to. Layoff announcements have beencoming fast and furious since the beginning of the year. If we were to list them all here itwould take several pages. We are seeing dozens of layoff announcements on the newseach and every day. On Monday alone there were lay off announcements totaling70,000 workers. There isn’t a single industry we can think of that is unscathed. A fewexamples: Circuit City (retail) laying off 30,000. Citigroup (banking) is planning to lay off52,000 over the next few months. Microsoft and Intel (computers) laying off 5,000 and6,000, respectively. ConocoPhillips (oil and gas) is laying off 1,350 workers. Pfizer and
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Sprott Asset Management
Royal Bank PlazaSouth Tower200 Bay StreetSuite 2700, P.O Box 27Toronto, OntarioM5J 2J1T: 416 943 6707F: 416 362 4928Toll Free: 888 362 7172
www.sprott.com
Wellpoint (healthcare) are laying off 2,400 and 1,500, respectively. This just in… Pfizerwill now be laying off 19,500, or 15% of its combined workforce, after its just announcedacquisition of Wyeth. Philips (electronics) 6,000 layoffs were announced. Sprint Nextel(telecommunications) 8,000 jobs were just lost. Home Depot (building products) 7,000 jobs gone. Caterpillar (industrial equipment) is cutting 20,000 jobs, or 20% of itsworkforce. The list goes on and on and on. Lest you think governments are exempt, thestate of California has plans to layoff 20,000 state employees, or 10% of its workforce. Itwouldn’t be too much of a stretch to say that nobody’s hiring, and everybody’s firing.Unfortunately, we believe the announced job cuts thus far are only the beginning. Forthe most part, the drop in sales that companies are experiencing has been far steeperthan the announced reductions in headcount. Eventually, employment will need to bemore in line with sales. Which is why we believe the unemployment rate will skyrocket in2009. Remember the 20%+ unemployment rates seen during the Great Depression ofthe 1930’s? Don’t get lulled into a false sense of security by thinking that those days arelong gone, never to return. They very well might before 2009 is out. As we mentioned inthe introduction, the world is experiencing a global economic catastrophe, whereweakness becomes self-feeding, begetting even more weakness. As more and morepeople lose their jobs, their contributions to the economy will decline. There will be moreand more home foreclosures and credit card defaults, and even more problems in thebanking sector, leading to further wealth destruction. There will be even fewer peoplebuying cars, or buying anything for that matter. As consumer spending declines, so willcorporate sales, leading to further layoffs, resulting in fewer customers and even weakersales, etc. It’s a vicious circle.So why aren’t the solutions of the brain trust we mentioned earlier working? What aboutall the stimulus? Central bank interest rates the world over are the lowest they’ve everbeen (essentially zero) and they’ve already been adopting unconventional monetization/ money printing measures not seen since the Great Depression. Then there is the TARPand TARP II, and the hundreds of billions, if not trillions, of dollars that have beenthrown, and are still being thrown, at the financial system to bail it out. Furthermore,governments the world over are promising massive spending programs to kick starteconomies. Both monetary and fiscal stimulus are set to full bore. Why isn’t al
l
thisstimulus working?It doesn’t take a Masters degree in Mathematics to understand why none of this hasmade an iota of difference so far. All it takes is a back-of-the-envelope calculation ofhow much wealth has been destroyed over the past couple of years. Let’s begin withthe stock markets. At their peak, global stock markets had a market capitalization ofapproximately $60 trillion. Since then they’ve dropped by half, resulting in
$30 trillion
oflost wealth. That’s just stocks! The other major source of wealth for people is houses.Taking the US as an example, the latest Case-Shiller readings show that housing pricesare down almost 25% from their peak. There are over 100 million homes in the US, andthey once had an average price of just over $300,000. Multiplying the three numberstogether we get $7.5 trillion of lost wealth in the US from the fall in housing prices. Sincethe housing bubble was by no means confined to the US (where, it was in fact quitetame compared to other markets), let’s multiplythat number by four (the inverse of theUS share of global GDP) to get a conservative estimate for the global fall in homevalues. That, coincidentally, equates to another $30 trillion, for a total of
$60 trillion
inlost wealth, give or take, just from stocks and houses. This doesn’t even include thelosses from other asset classes that have been decimated, such as corporate bonds,commodities, and commercial real estate. But let’s just stop there. This crude but simpleanalysis already shows the magnitude of the problem that needs to be overcome. Theglobal wealth destruction that has taken place dwarfs anything that has been spent on
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Sprott Asset Management
Royal Bank PlazaSouth Tower200 Bay StreetSuite 2700, P.O Box 27Toronto, OntarioM5J 2J1T: 416 943 6707F: 416 362 4928Toll Free: 888 362 7172
www.sprott.com
stimulus and bailouts. This is why it has failed to stem the tide. A trillion or two or three(or even ten for that matter) just isn’t going to cut it. As desperate and as generous asgovernment solutions may seem, they are but drops in the bucket compared to what’salready been lost.That said, we believe there is another, even more fundamental reason why governmentsolutions can’t work. Although there are those who would espouse that the ‘freemarkets’ have failed, we are of the belief that it is government involvement in the freemarkets that failed. Specifically: (1) central bank attempts to keep interest rates farlower than what free markets would have warranted (especially post-9/11), supportedby the lie that inflation was non-existent, (2) the existence of government-sponsoredenterprises such as Fannie Mae and Freddie Mac, fuelling ridiculous excesses inmortgage finance and credit availability from ever-rising housing prices, (3) the moralhazard that ran amok as it became obvious that financial institutions can take egregiousrisks partly because they became “too big to fail”, and (4) the existence of anunprecedented current account deficit in the world’s reserve currency, financed bygovernment-run foreign institutions (central banks and sovereign wealth funds). Webelieve it is these factors, especially the first, that caused the bubble in the first place. Itwas predominantly government-induced and not a failing of free markets. The endresult: too much debt and an economy that, at its foundation, became dependent onpeople spending beyond their means. Those days are likely gone, never to return.There’s been a paradigm shift – a permanent change. People will save rather thanspend more than they make. The implications for the economy are enormous. Justenvision a world where 25% of all shopping malls close down and try calling that arecession.So here we are today with governments the world over taking an increasing role in thefunctioning of the economy and the financial markets. But are they trying to solve themain problem; namely, too much debt? Quite the contrary, every single solution they’veadopted has been trying to get the good ol’ days back. Cutting interest rates to zero.Throwing money at the banking system so it can lend again. All these solutions haveone goal: to bring back
debt
. They are ignoring, at least for the time being, theparadigm shift. But the markets aren’t buying it… literally. Debts continue to implode.Every bailout is being followed by an even more massive bailout down the road. Thegovernment’s solution has been to shift debt from the financial markets to the taxpayer.Is there a difference? Instead of individuals living beyond their means, we now havegovernments living beyond their means. Substitute
taxpayers
for
governments
and youwill quickly realize how the whole thing is a farce. Take no solace in the fact that thegovernment is the buyer of last resort. It is really
you
who are the buyer of last resort. Inthe end, people will be even more indebted than they were before, setting the stage forthe next crisis: a currency crisis. This is why governments aren’t, and cannot be, thesolution.Government deficits are already out of control, and this is before spending even a dollaron fiscal stimulus. In the first threemonths of this fiscal year, the US government ran a$485 billion deficit. This is already worse than the deficit for all of 2007. In December,government tax receipts were down an astounding 14% from last year. The dramatic falloff in revenues is sure to have a greater impact on government budgets than actualgovernment spending. We’re seeing the same thing here in Canada. The latestforecasts show the government going from a $13.8 billion surplus in fiscal 2008 to a$30-35 billion deficit over each of the next two years – a $44 billion swing, at least. Yet,there have been barely any announcements of new government spending. Most of the
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