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Macro
First Quarter
January 9th , 2009
Damien Cleusix
d i @ l 6
damien@clue6.com
“It’s frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by
people who have faith that they know exactly what’s going on”
A. Tversky
“The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies
taking each particular risk”
S. Klarman
“Risk means that more things can happen than will happen “
E. Dimson
“The more you bet, the more you win…when you win”
Las Vegas saying
Macro
The collapse has been avoided thanks to the resolve of Central banks and governments around the world but we will still have
to deal with the aftermath of the biggest credit bubble in history.
history They have managed to prop up assets prices (buying them,
them
changing accounting rules and providing huge amount of emergency liquidity) and lower interest payments pushing debt to
asset lower and improving interest coverage but they can not do this forever…
The recession which p probablyy ended sometimes during g the summer was not a typical
yp inventory-led
y one were more that 75% of
the decline is due to de-stocking. It was the beginning of a "balance sheet" recession which is going to haunt us for many years
with poor growth and intermittent relapse into recession (here we are talking about developed leveraged countries, financially
unleveraged developing countries will suffer because of their operating leverage but will end up as winners if they do the right
reform)
The deleveraging process in unavoidable. Analysts have spent a great deal of time commenting on the collapse of credit
availability but we think the biggest problem for growth in the medium-term will be a lack of credit demand. Many households
and companies have realized that they could go under and they are going to build a buffer...
Nationalism and protectionism will gain in popularity while there is a big risk of regulators going on a rampage (we see a
strong risk of this cyclical ERROR like the commercial banks reserve increase in the 30’s or the VTA hike in Japan in the 90’s
here) after doing too little for so many years…Populism will be a winning strategies for politicians, even more than before…
The current macro data has surprised on the upside with the success of the cash for clunkers schemes around the world (which
probably added up to 4% to US growth in the third quarter), various forms of help for first time home buyers, the socialization
of the credit market in the US and Europe or the credit explosion in China... We continue to see the current improvement as a
normal snap back from the worst macro environment since the 30's. It should not be confounded with a strong recovery.
The traditional swing factors I.e. inventories, residential investments and autos which have historically accounted for almost
all the volatility in GDP are not expected to have the same impact as in the past (and the autos part is probably already
behind us,
us in the US and Europe at least).
least)
Consumption should continue to be a drag in the developed world for some times. Aggregate disposable incomes and net
worth evolution and their influence on savings should be followed carefully as they will be the keys on how quickly the
consumption
p behavior will change.
g
The fate of the current recovery hangs on the exit strategies for the monetary and fiscal stimuli, how the financial markets
will interpret them and the unavoidable errors which will be made…
Fiscal Stimuli have been helpful but their long-term effect will be sub-optimal as long as they are considered as a short-
term fix and that they are not constructed to foster future productivity and labor market growth. Much more is needed as
they have, for the moment, only been able to compensate for the loss of other income in the US.
Central Banks will have to first give clear guidelines on how they are going first to exit the qualitative phase of their
easing now that markets have normalized. They should do the same for the quantitative part. The QEs were legitimate (even
in our eyes...) to avoid a total freeze and collapse of the credit markets and a debt deflation dynamic to develop but not
otherwise.
Deflation is still a real risk (we would even say a fact…) and we would thus like to see the quantitative part continuing a
bit longer. Central Banks might even start charging instead of paying interest on the reserves they hold on behalf of the
commercial banks. This would encourage them to put the money elsewhere into the economy. The Swedish Riksbank has
started such a scheme and the BoE is discussing the same...
Expect macro numbers to continue to move in the right direction (and in the next 3-6 months the rate of change is likely to be
increasingly positive as it will be calculated against 12 month old data...) until Q2 2010 at least.
After that… we should remember that we are living in the aftermath of the biggest credit bubble in history. This does not
necessarily imply a double dip as much will depend on the behavior of households and the impact of fiscal and monetary
authorities policies or lack of policies...
Europe should be the focus of your attention as there is a high probability that the next “crisis” will have its epicenter there…
In the next few years the world economy will be more volatile than in the 20 years pre-2007… with dramatic
consequences on assets valuation ratios (cheap tomorrow will be much cheaper than what was deemed cheap between
1990-2007)…
Once more, but needed to put the rest of our macro analysis into perspective…
The NYT recently published an article by R.Shiller titled "An echo Chamber of Boom and Bust". He wrote:
"What happened? Economic analysts often turn to indicators like employment, housing starts or retail sales as causes of a recovery, when in fact
they are merely symptoms. For a fuller explanation, look beyond the traditional economic links and think of the world economy as driven by
social epidemics, contagion of ideas and huge feedback loops that gradually change world views. These social epidemics can travel as swiftly as
swine flu both spread from person to person and can reach every corner of the world in short order."
That's it... At turning points, markets trends change as the investors universal beliefs are proven wrong while during trends the markets
make the opinion... At turning points, the triggers are often hard to identify (in hindsight it always seems a self evidence). It is thus important to
try, as much as possible, to identify the potential triggers before they occur. Finally the key is to see how the markets react when they happen to see
if they really are the “turning point”. Market perception is the key and the less it can discount the consequences the larger the consequences…
Since the Spring of 2006 we have been warning that the credit build up the world economy (mainly US and Europe) was experiencing would lead
to a major shift in governments, banks, investors and consumers perceptions and behaviors. A shift that would be a generational event (so it
should last for approximately
pp y a ggeneration).
) Regulators
g would wake up,
p banks behave like banks, investors rebalance, byy reason or constraint, their
portfolio toward less risky assets and consumers spend less than what they earn.
The chain of events have unraveled as expected and should continue to do so. As with every trend, this development will not be linear and we
will have phases when investors will believe that the sky is the limit but they will be proved wrong. We will surely see some bubbles develop and
pop along the way but the wash out will take much more time than one thinks. (As we said some emerging economies will be able to do quite well
if they have the courage to make the necessary domestic reform and let Bretton Woods 2 die away)
This credit bubble was a bad bubble...It was mainly financed by banks and impacted unproductive assets, houses. The end result is that banks
can not lend while there has not been any addition to the productive capacity… This bubble will also generate new regulations which will imperil
financial innovations in the future (some will be good and necessary, some bad) and lower banks capacity to lend. Money velocity will decline…
The bubble was born out of the belief that Central Banks had tamed the business cycle and that they would use any means to prove it.
Yes, technological advances, the imagination of the investment banks and hedge fund quant desks or the semi-coma in which regulators seemed to
have fallen allowed it to reach unheard of proportions but without this deification of Central Banks it would not have reached such a monstrous
size. Apparent, believed stability, led to too much risk being taken and instability. A. Greenspan called it the "Paradox
Paradox of Credibility
Credibility“..
The confidence in the system has now been eroded but not as much as one would have expected... Indeed, many believe that the Fed has saved the
day… once more.
Finally it led, by artificially lowering the cost of capital, to a global expansion of capacity which is going to haunt us for some time.
Overcapacity
p y will dramaticallyy reduce the “earningg ppower “ of the gglobal economy,
y, especially
p y where the operating
p g leverage
g is high.
g This will in all
likelihood encourage new protectionist measures around the world (not to be compared with the 30’s but…
The consequence will be what Pimco’s B.Gross calls the “New Normal” I.e. deleveraging (both financial and operating), deglobalization and
reregulation…
g
We continue to see the current phase as simple normalization from the panic experienced at the end of last year and earlier this year on the back of
an aggressive rise in excess money (monetary expansion over GDP growth or industrial production) and huge fiscal stimuli (even if beside China, a
big chunk of the announced stimuli is yet to be spent). The impact has been much stronger on non-financial leveraged economy were the
multiplication effect was in full swing (and was also helped by some government directives in less democratic countries like China). Trade was
frozen as letters of credits could not be emitted, companies panicked slashing down production (with industrial production falling much more
rapidly than sales) and laying off workers en masse. The latter point applies especially to the US.
The Conference Board leading indicator monetary and financial indicators remain strong while the
real economyy indicators are risingg much less vigorously...
g y
The Japan Economy Watchers Expectation survey has continued to deteriorate (Chart 2).
Remember that Japan is leveraged to the global cycle and has tended to lead other countries (note
that the Yen strength should also be taken into account... so maybe not as bearish as otherwise...).
As an aside, the Topix correlation with this survey is extremely high so use it when looking at
your Japanese market exposure…
All in all, growth expectation could be too low for Q4 2009 and Q1 2010 while the expectation for
Q3 2010 and forward are probably too high... but a lot depend on the evolution of the fiscal
stimuli, the Central Banks stance and, partly as a consequence, when the next shoe, probably
Source: J.
J Hamilton
Europe, drops...
Let's call them the swing factors. They are inventories, residential investment and autos. They Chart 4 US GDP and Swing Factors
might represent a low percentage of the overall GDP but believe it or not they have contributed to
all of the GDP decline in previous recession before the current one (without them we would not
have had a recessions…).
recessions ) They also contributed to a big part of the initial rebounds (Chart 4)...
4)
Inventories have less influence as they represent a smaller share of GDP and they remain
high (Chart 5). But one has to remember that it is the inventories quarterly rate of change which
counts so even if inventories continue to decline in Q4 they will only have to decline less than in
Q3 to have a positive contribution to GDP… They will add up to 4.5% to the growth announced
for Q4 2009 and Q1 2010. Note that ISM inventories indices are falling again (to 8 months low)
despite the fact that the supplier deliveries is above 50… Inventories are hard to finance which
leads to potential sales lost…
For autos,, the cash for clunkers scheme ((and similar pprograms
g in Germanyy and other countries)) S
Source: Morgan Stanley
S l
has, beside encouraging people to take on more debt (yes more...), pushed forward future
Chart 5 Census Bureau Businees
sales. This is the past, history and the only lasting mark is a relative increase in consumer Inventory to Sales Ratio
leverage and some auto manufacturer stocks slowly becoming attractive short again (Ford,
Fiat,…)
Residential investment is not likely to be a major drag for future growth now that it
represents 2.3% of GDP from a 6% peak and a historical 4.5% average but the first time home
buyer tax credit has been extended both in time and scope which will be helpful. Previous
rebounds have been the result of short supply and as we will show later, supply is plentiful
even if the visible one has decreased substantiallyy in the p
past few month, courtesyy of the tax
credits...
Let's not forget that the last 2 factors are usually debt-financed and debt is harder to come by
these days (and actors not necessarily willing to borrow… see balance sheet recession
later)...even if governments are directly or indirectly lending money. Source: Bloomberg,
Bloomberg Clue6
It leaves us with government spending, private investments, consumption and export... Chart 6 US Fixed Investment to GDP Ratio
Government spending and consumption will be analyzed in more details later. We will show that
ggovernment spending
p g will have a major j ppositive impact
p in the short-term but then… while
consumers spending, while it might continue to rebound in the medium-term, will slow again as
soon as their net worth starts to decline again…
Private investment have been declining rapidly recently (Chart 6). This is a global phenomenon
for developed economies. Even in Japan, the perennial "over-invester", fixed capital investment
as a percentage of GDP have declined to 20% from 24% a year ago and a 32% peak in 1991.
In the US there are no net private investments (Chart 7)... despite the fact that companies
have a positive financing gap. This is typical of balance sheet recession where debt reduction is
more important than profit maximization...
S
Source: Bloomberg,
l b Clue6
Cl 6
Anyhow, we should witness increase capex in the quarters to come with the Conference Board Chart 7 US Net Private Investments
CEO Confidence index recently rising above 60 which is consistent with YoY 8% capex growth
in the quarters to come...
For exports, we might have a positive surprise given the very low USD and the fact that the US
labor force has declined much more than the GDP while it has only declined by 1% in
Europe and UK and 2% in Japan.
Higher productivity, lower currency and companies eager to find new market to compensate for
the sluggish domestic one, what more could you ask for...
Source: Morgan Stanley
Global trade has finally started to rebound with growth accelerating in the recent past
(Chart 8). It is still 14% below the April 2008 peaks but the September MoM increase was the Chart 8 World Trade Volume
biggest on record…
We thought the decline was exaggerated by the almost impossibility to get letters of credit for
trade late last year and that it would warrant at least a small snap back… so far so good…
Export growth in South Korea (more timeliness and strong correlation with the world trade data)
has continued to improve but the recent rebound into positive territory is mainly due to the base
effect (November last year was horrible).
horrible) In fact export are lower today than in September…
September
Manufacturing companies have been underperforming relative to the KOSPI for some time and
it has been a good leading indicator of deteriorating exports… The underperformance has
accelerated recently…
S
Source: Netherland
h l d Bureau for
f Economic
i Policy
li Analysis,
A l i Clue6
Cl 6
Protectionism has been again on the agenda recently (many fiscal stimuli had a buy domestic
bias but this was not a bilateral measure so less likely to make the front page). We are also Chart 9 South Korean exports
seeing a lot of new capital control measure being instituted (Brazil, Indonesia, South Korea,
Taiwan, Russia…) and some devaluation (Vietnam).
Expect this trend toward greater protectionism and/or competitive devaluation (even the SNB
does it nowadays) to continue going forward, especially when the growth cycle will turn down
again...but do not expect a return to the 30’s tariffs and trade wars…
Remember that protectionism is one of the five government cardinal sins according to
Charles Gave. The others are war, monetary policy mistakes, increase regulation and tax
hikes.
It was developed
d l d when h analyzing
l i theth economic
i
agents behavior following a credit bubble (see
"The Holy Grail of Macroeconomics: Lessons
from Japan's Great Recession“ by R.Koo).
In this environment,
environment household and business
reduce their debt despite massive monetary
accommodation as many individuals and
companies have bigger liabilities than assets.
On Chart 12 and 13 one can see that the credit Chart 12 Euro and US Libor-OIS Spread Chart 13 Moodys BAA Spreads
markets have mostly normalized from the panic
levels of late last year…
Delinquencies are still rising and we are entering in the second phase of exotic mortgage resets (Chart
19) which will have a dramatic impact (bank loss, increase in foreclosure,...).
A relapse is a possibility (but not a certainty). In this regard one has also to note that many great
investors (D. Tepper, L. Ainslie) and some of the most prominent member of the "those who saw it
coming" group (J. Paulson...) are positive on the large bank stocks... So the jury is still out...
We will have to monitor carefully bank relative performance (stocks and CDS)...
Source: FDIC
There are other risks one should keep in mind… High Yield and Leveraged Loans
Chart 21
Refinancing Needs
Regulations imposing lower leverage on banks, minimum standard funding liquidity, counter
cyclical capital buffer or off balance sheet entities ban will lower lending capacity and could
cause a new wave of volatility in the markets.
FASB 166-167 which should start to apply during Q1 2010 will bring back more than usd 500
bio. off balance sheets assets into the "big 4" sponsoring entities balance sheet in the US
(and we now know that SIV assets can be of dubious quality...)
Basel II should also start to be implemented at the start of 2010. When one see that Japanese
banks can rise more than 10% on an article implying that the rules implementation might be
delayed, one can see that they won't be optimal on a bank profit maximization angle...
The imposition
Th i iti off compulsory
l contingent
ti t convertible
tibl debt
d bt for
f banks
b k andd the
th affirmation
ffi ti that
th t S
Source: Barclays
l
government assistance will only be junior to depositors would also increase banks funding
Chart 22 Banks Debt Average Maturity
costs…
There is also the refinancing risk with refinancing needs rising strongly just when government
andd central
t l banks
b k will
ill be
b forced
f d to
t tighten
ti ht the
th grip
i by
b markets
k t (well
( ll governmentt att least)...
l t)
10% of the US high yield market will mature in 2011, 15% in 2012, 17% in 2013 and 20% in
2014. In 2014 alone usd 350 bio. of high yield and leverage loans will have to be refinanced in
the US and eur 60 bio. in Europe (Chart 21)…
Some insiders are predicting that up to private equity owned companies, employing 3.75 mio.
workers, will go under between 2011-2015 (“The Buyout of America”, J. Koshman) as they
struggle to refinance the almost usd 1 tn. dollar that will come due...
Banks debt average maturity has also declined from 7.2 7 2 years 5 years ago to 4.2
4 2 years today.
today Source: Moodys
Usd 7 tn. of their debt will mature by the end of 2012 (Chart 22)...
Emerging markets refinancing needs will also be very important (especially in Eastern Chart 23 External Debt Refinancing Needs
Europe) (Chart 23). One has also to take into account the need to finance the budget deficit on
top of that and here again, Eastern Europe come into mind...
On Chart 24, one can see that European banks are most exposed to this risk, with more than
75% of the loans to emerging markets.
We have long argued that the next phase of the crisis will have its epicenter in Europe...
There are sovereign problems (Greece, Spain, Irland, Italy, Portugal, Austria), banks have been
much more timid to recognize their loss than their US or Japanese counterparts and are very
exposed to Eastern Europe (which will experience an Asia 97-98 like crisis... not a question of if
but when...).
S
Source: S
Source: ““World
ld Economic
i Outlook”
O l k” , IMF, April
A il 2009
Furthermore as we will see later, European government are likely to tighten their budget first, Liabilities to Advanced Economies’
European companies are less competitive (high currency, not enough firing,...) and the housing Chart 24 Banks (% GDP), 2007
bubble has yet to pop.
The market is now starting to realize the sovereign problem with Greece (but it is just a
beginning) and the bankruptcy of Hypo Group Adria (HGAA) in Austria is putting European
Banks and their Eastern Europe exposure back on the table. Note that while HGAA might seem
small, for Austria it is equivalent to a bank with usd 2.5 tn. in assets...
Will a bank bankruptcy in Austria be one more the first domino to fall...
fall remember Kredisanstalt
in 1931...
As always, once we have identified potential risks, our role will be to monitor the indicators
which will show if they materialize...
Source: IMF
With deflation nominal incomes are likely to decline or only grow slowly, increasing the need to
pay back debt. Real rates will also be positive even if nominal ones are at 0…
But as J. Bullard, president of the St. Louis Fed, recently said, productive capacity might have
fallen (our no net investment graph before and the fact that many of the job losses are not cyclical
are confirming this hypothesis), the output gap might be much lower than what is currently
believe…
S
Source: Bloomberg,
l b Clue6
Cl 6
Psychologically one should also take into account that the base effect will be negative in the
months to come (rapidly declining price 8-12 months ago). We could have 5-10% inflation rate on
a YoY basis in some emerging market countries (India,…)… Will be interesting to see of the
Central Banks and markets react… Especially if food prices continue to rise (remember 2008
and the consequence it had in emerging markets…)
But ultimately we still think that deflation will prevail… when we relapse at the end of 2010
beginning of 2011… A potential scenario, as in 2008, would be an initial inflation scare (with
rising inflation expectation, which will pave the way to a new phase of deflation)
Did you know that there has not been any net
private job creation in the past 10 years in the
US Yes productivity has been rising fast but what
US...
if it ceased to be a major driver of growth (as we
expect... it has long cycle and we are near/at the
top)... In 2007 we wrote that the US potential
growth was overestimated... It still is... and we
prefer not talking about Europe... while for Japan it Source: Bloomberg,
Bloomberg Clue6 Source: Bloomberg,
Bloomberg Clue6
is so low that we are almost certain that it will grow
quicker than estimated…
Small companies (less than 500 employees) are employing 65% of the US workforce (Table 1)...
In the past 18 months, the smaller companies (less than 50 employees, less than 30% workforce)
have accounted for 45% of the job losses while in the previous recession it lost only 9%...
Given the readings of the various NFIB survey components, they do not seems to be ready to
hire...
Nevertheless, the employment picture should improve in the medium-term (the models presented
in September is still indicating net job creation for Q1 2010). Do not forget that the government
will
ill hire
hi up to 1.5
1 mio.i persons for
f theh 2010 census (this
( hi could
ld add
dd up to 700'000
00'000 jobs
j b to the
h May S
Source: BLS,
S x
nonfarm payroll), those jobs will be temporary but sometimes the market see only what it wants...
Table 1 Employment Distribution
Longer-term the job picture is grimmer...but we will analyze this in due time as it does not really
influence the near-term markets movement
Consumption can only deviate from incomes if savings are drown down and/or credit is
contracted… Aggregate paycheck should increase in the next quarter or 2 at least so this will
support at least some consumption (but note how depressed it is)… Then… the balance sheet
recession dynamic will prevail and consumption will grow less than aggregate income…
There are other important elements to take into account to get to the personal disposable
incomes aggregate...
Indeed total personal disposable income is composed of: compensation of employees received
(~68%), Proprietor Incomes (~9%), Personal interest and dividend incomes (~16%), Personal
current transfer receipts ((~15%)
15%) from which one has to subtract the contributions for government S
Source: Bloomberg,
l b Clue6
Cl 6
social insurance (~8%) less taxes which are less tan 10% today. Disposable Incomes Growth
Chart 32
Components
As one can see on chart 32, transfer and tax cuts have added more than usd 670 bio. (290 and
380 respectively). Without those contributions, disposable income would now be more than 5
% lower than 12 months ago... Note that Americans are now receiving 2 times more in transfer
that they are paying in taxes…
It is doubtful that taxes and transfers contribution to total disposable income will continue
to have the same positive contribution going forward. They might stay where they are but
will not add usd 670 bio. more next year… Wage growth will thus be determinant as proprietor
income and personal interest are likely to continue to fall while dividend incomes could rise
some but not much…
But there are other elements impacting disposable income and its discretionary use...
Source: Bloomberg,
Bloomberg Clue6
US Household Discretionary
Table 2
On table 2, courtesy of Goldman Sachs, one can see the various elements which can impact Cash Flow Sensitivities
discretionary disposable income.
Commodity
C dit prices
i can have
h a non-negligible
li ibl impact.
i t We
W have
h l
long said
id that
th t last
l t year’s
’ financial
fi i l
crisis masked the negative impact commodity prices had on global growth... We might have had
a commodity price induced recession even without the financial crisis... At usd 2.6 per gallon
unleaded gasoline is usd 1 higher than at the start of the year and much higher than the
level which were deemed to be impacting consumption negatively pre-2005. It has removed
usd 110 bio.
bio out of the consumer’s pockets.
pockets
Credit which we talked about earlier is removing usd 25 bio. for each % point of decline so
given the current 3.5% decline it has already removed usd 90 bio.
Source: Goldman Sachs
The other main element going forward will be savings (Table 3). 3) Will US households start to
save more or not. If one regresses net worth to saving, savings seems to be were they should.
GDP Change given Various Personal
Table 3
Disposable Incomes and Saving Rate
Our contention has been that the bursting of the credit bubble would change mentalities
for a generation at least. Never before have they seen what over-leverage could do. They might
have heard about it but there is nothing better than real experience to grasp an abstract concept...
concept
So our most bullish guess is that saving will rise to 5-7% next year and disposable income
will fall 1-3%. The impact on GDP will be between 2.46-5.98%. One could add a 0.5-0.75%
impact from continued consumer credit fall for a grand total of 3-6%. If we were forced to
we would bet that we will be in the middle range...
range Ceteris paribus,
paribus the non-private consumption
GDP components would have to add as much for GDP to be flat... Source: Clue6
So going forward we will have to follow closely how total compensation evolves...
We also have to repeat what we said in June and September... There are 5-8 mios houses sold every year
in the US.
US The 8 mios units were reached while homeownership rose from 64% to 69% during the pas 15
years (against an historical average of ~64.5%). We expect homeownership to fall back to 64-65% in the
coming years which implies that we will have demand for 4-6 Mios houses during this period. If you
consider that there are approximately 7 months of sales in inventory, this limits the potential for prices to
move up but there is more to this…
Indeed, we can expect to have approximately 2 mios foreclosed homes to hit the market on a yearly S
Source: First
i American
A i C
CoreLogic
i
basis in the next 3 years (Chart 37)… US New One Fam. Houses Median Nbr
Chart 38 of Months For Sale Since Completion
Things could get even worse as US household percent owners equity in real estate has fallen to just above
40% recently. If you consider that, according to the Census Bureau, 32% of house owners did not have a
mortgage one can estimate that mortgage owners have,
mortgage, have on average approximately 20% equity in their
houses.
T2 Partners estimates that 24% of mortgage owners owe more than the house is worth (up from
6% at the end of 2007). Moody's estimates is the same. If home prices were to decline by 20% more
we would have more than 45% of homeowners underwater... Deutsche Bank forecasts 48%
homeowners underwater in Q1 2011... and that this time it will hit the prime market (80% of the mortgage
market in the US, 65% for conforming loans and 15% for jumbos). 41% of conforming loans are forecast
to be underwater against 16% today (47% vs. 28% for jumbos)...
One important element here will be how homeowners react when underwater... In a recent paper
Moral and Social Constraints to Strategic Default on Mortgages
"Moral Mortgages" the authors see that strategic default Source: Bloomberg,
Bloomberg Clue6
(default even if you can afford to pay your mortgage bills) is likely to increase dramatically when
homeowners are more than 15% underwater...
Source: The Holy Grail of Macroeconomics: Lessons from Japan's Great Recession, R. Koo
As we have said the fiscal stimuli should be oriented toward growth-enhancing investments and
should be temporary for the non-productivity enhancing reforms (need a new vote to be prolonged).
Th should
They h ld beb temporary to limit
li i the
h increase
i off the
h reall interest
i rate which
hi h would
ld decrease
d the
h
stimuli effect on the economy. Its main goal should be to increase productivity and encourage
people to work, the 2 motors of growth.
In the US, many reforms are permanent and as J. Hussman puts it:
“…our policy makers have aggressively crowded out private investment through this bailout
policy, which allocates good capital to the worst stewards, and they have done virtually nothing to
abate the housing downturn.“.
Furthermore the cash for clunkers and tax credit for first time home buyers
y are encouraging
g g S
Source: stimulus.org,
i l Clue6
Cl 6
present consumption at the cost of investments...
Table 4
With regard to housing we repeat that we favor a debt to equity swaps where over-indebted
homeowners would give a participation to the future value of their house in exchange to a
diminution to their debt balance today. The more details we get from the moratorium on
foreclosure and HAMP program instigated earlier this year, and the clearer it becomes that it is not
working...
Anyhow for the short-term it is the amount of money which is spent which count (unfortunately)
and there are plenty more to spend (Chart 39) and Table 4. Only a third of the ARRA has been
spentt to
t date
d t while
hil there
th are almost
l t usdd 400 bio.
bi Extended
E t d d provisions
ii t come…
to
And keep in mind that there is a lag between the fiscal thrust and the fiscal impact…
When looking at the cyclically-adjusted budget balance (Chart 40, next page), one see that it is
expected to improve next year,
year but we would not necessarily consider it as a sign of tightening if
the improvement is due to a rebound in tax revenues not provoked by a rise in tax rates…
Source: Stimulus.org, Clue6
The Hoover Status Quo: decreasing aggregate demand and precipitating a double dip recession in order to reduce
government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt
repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would
simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain
dependency on foreign sources of capital – all without ending the spectre of big government.” (E. Harisson)
We will see… the fact that there are few in the current administration with a private sector experience (Chart 41)
increase the risk that solution 1 and especially
p y 3 will be chosen… But then the market might
g force their hand…
Keep in mind what happened in Japan every time spending momentum faltered on a 12 months YoY basis…(Chart
42) and spending will have to be cut and/or taxes be raised as soon as the economy show any sign of durable
growth. >3% real for 12-18 months)
Only 2 states have balanced budgets and 9 are in distress... One can almost read daily on
California woes in The Journal (and remember California is would be in the top 10 world GDP
if it was a country...).
Deficits are estimated to reach usd 180 bio. in 2011 and usd 120 bio. in 2012, if the economy
recover (Chart 43)...
One of our past concern was that part of the federal ARRA stimulus would be used to fill state
and local budget.
One can see that states and locals expenditure have yet to be cut (well once again if you do not
live in California...) because the federal government has been helping (Chart 44).
S
Source: C
CBPP
And do not only look at the recession induced problems but the more structural cost structure Chart 44 States and Locals Tax Revenue,
with extremely high health care and retirement benefits for public workers and as a Expenditures and Federal Grant in Aid
consequence the grossly underfunded pension and "other post employment benefits" (OPEB)
funds...
So this is not only an income statement problem but also a balance sheet problem...keep an
eyes on them...
Source: BEA, x
There are countless episode of bubbles in financial history and in political history...
It continues (and you hear " it has been so in the x past years and we did not have a problem so
why worry now...") until... it stops...
Could investors and the public start to price the real fiscal imbalance their countries are facing
(Table 5, note that this ratio is above 500% for the US too) sometimes in the next few years
now that the "traditional deficits" the press is always talking about are exploding?
The consequences will be a big increase in savings as citizens will slowly come to realize that
they won't get what they were promised and increase in real rates as even if the system is
reformed (increase pension age, lower pension. higher contribution...) it won't be sufficient to
avoid a fiscal crisis in manyy countries... Time to realize that the "acquis
q sociaux" were not a
right but something which the state provided when they could... they can not anymore...
A risk to keep at the back of one's head (and as always the market will probably give clear
signal when to really worry about it as an investor... but as a citizen it is already too late...)
Source: Measuring
S M i ththe Unfunded
U f d d Obligations
Obli ti off E
European C
Countries
t i JJ.
Another area were many emerging markets (ex Eastern Europe and some Latin American Gokhale
countries" have a big comparative advantage...
Central Banks are now facing a strong dilemma to decide when to normalize and how to
S
Source: Bloomberg,
l b Clue6
Cl 6
communicate it...
Risky assets are rising strongly while the economic recovery is still in its infancy. By tightening too soon they risk killing a weak recovery. By
tightening too late they risk re-inflating the same kind of bubble which brought us where we were 6 months ago... Furthermore they also must to
take into account that many unconventional measures have been implemented and that there are no prior record on how or when they should be
exited...
exited
The exit should be coordinated with the government so that both fiscal and monetary stimuli are not exited at the same time. This adds another
layer of complexity where errors could be made…
The Central Banks should first exit the qualitative easing measures.
measures Qualitative easing can be defined as changing the mix of the asset side of the
Central Banks. One part was active while the other was passive I.e. accessed at the private sector’s discretion. The exit of the passive part should not be
considered as tightening but rather as a positive sign that the private sector feels strong enough not to need the Central Bank's hand. For the active part,
programs should be run down slowly and its impact on risky spreads analyzed carefully.
As an aside, failure to communicate on the exit strategies, would be very detrimental to the
Central Bank national currency (but this might be something they aspire to but do not dare to
say…).
S
Source: Federal
d l Reserve Boardd
It is more dependant on export, its currency is overvalued and its central bank was rising rate late
last summer... It lacks the flexibilityy and the culture of success ((defined as a failure beingg an
experience and not a stigma) of the US. The labor force only declined by approximately 1%
compared to 5% in the US… Guess who will be more competitive…
The Eastern Part is on the brink and a crisis (Chart 47) much more severe than what happened in
South-East Asia will onlyy be avoided if the IMF and the EU show strongg resolve... Source: IMF
In Japan, the leverage problem has corrected during the last 20 years and if we do not take the Chart 48 Topix and Nominal GDP
high share of banks assets invested in equities, the situation looks better than in the US and
Europe. The Yen is too strong and as long as trade flows remain low do not expect a strong
recoveryy and this is what the Economyy Watchers Expectation
p index ((Chart 2)) is confirming…
g
Gross capital formation has slowed rapidly recently and this is a positive going forward as Japan
continued to overinvest long after the bubble burst in 1990…
It should find a way to increase the number of people working (more women in the workforce and
more openness to immigration). We expect productivity to be a positive surprise in the next 5-10
years as the country slowly turns shareholder friendly.
The DPJ victory might be a catalyst but reforms will take time, lots of it to be implemented…
So rce: Daiwa
Source: Dai a
South-East Asia has experienced its debt deflation approximately 10 years ago. Balance sheets at all levels are healthy. The problem remains too
high a dependency on external demand. The big stimuli should be used to rebalance their economies toward less capital intensive industries and
toward labor intensive service, easier access to credit and improvement of welfare.
With regard to China, honestly, we do not know as we can’t trust… It is still a relatively young economy which is likely to experience some
booms/busts in the years to come. We are puzzled by the admiration many have for the influence the government has on the market and its
perceived proficiency… Never confound luck with talent…
We will write a chapter on it in the next quarterly were we will see if there is/are bubble(s) or not as a crisis would have enormous consequences on
many assets…
Latin America remains dependant on commodities but one could have genuine hope that the region won't fall back to its ills of the 80's and 90's.
Their fiscal stimuli should have the same aims as the South-East Asian ones.
So, the US needs to save, Europe to revolt, Japan’s consumers to wake up and Asia/Lat Am to spend….
We would avoid large CA deficit countries with high need of foreign capital as foreign investors are in a lose/lose situation. Either they devalue or
they do nothing and the domestic economy collapse.
We would favor CA surplus countries with high domestic savings and low leverage. They will be long-term winners but are likely to suffer greatly
from the fallout of the above-mentioned.
It will be important to see which countries in this group will be making reforms that encourage the emergence of strong domestic-oriented
economies and ready to let their currencies appreciate. This group will be the big winners in the next 10-15 years…
One of the area which was identified as a potential growth engine in the future in the US was investments.
Investment needs to be financed and while companies are saving a lots(but they have high absolute debt to equity levels), the US total net saving has turned
negative for the first time…
Thi is
This i nott goodd for
f investments
i t t on a medium
di t longer-term
to l t b i especially
basis, i ll when
h so much
h off the
th US liabilities
li biliti are already
l d on foreigners
f i h d
hands…
The housing bubble has bursed in the US but not elsewhere (except in Japan, Germany and Switzerland)…
In many countries the initial loan to value ratio is similar as in the US and you often have the possibility to loan the rest at a higher rate…
An important difference is that in the most affected US states mortgage are nonrecourse loans I.e. secured by a pledge on the real property but for which the borrower is not
ppersonallyy liable,, this encourage
g the lender to find a solution and,, above all,, limit both in time and length
g the impact
p of a housingg decline on consumption
p ((wealth effect is
lower)…
The triger for a correction in Europe are probably higher interest rate and/or fiscal tightening… To observe attentively… especially in Europe including the UK and Australia
Clue6 First Quarter 2010
Macro: Consumption 35
Interesting to see that healthcare account for all of the increase I spending in the past 50 years…
As the ppopulation
p ggrow older the pproportion
p spend
p on healthcare is likelyy to rise,, leavingg less for the rest…
Maybe the healthcare sector will be the victim of a witch hunt sometimes in the future…
Macro
The collapse has been avoided thanks to the resolve of Central banks and governments around the world but we will still have to deal with the
aftermath of the biggest
gg credit bubble in history.
y Theyy have managed
g to ppropp upp assets pprices ((buying
y g them,, changing
g g accountingg rules and
providing huge amount of emergency liquidity) and lower interest payments pushing debt to asset lower and improving interest coverage but they
can not do this forever…
The recession which probably ended sometimes during the summer was not a typical inventory-led one were more that 75% of the decline is due to
de-stocking.
g It was the beginning
g g of a "balance sheet" recession which is ggoingg to haunt us for manyy yyears with ppoor ggrowth and intermittent
relapse into recession (here we are talking about developed leveraged countries, financially unleveraged developing countries will suffer because
of their operating leverage but will end up as winners if they do the right reform)
The deleveraging process in unavoidable. Analysts have spent a great deal of time commenting on the collapse of credit availability but we think
the biggest problem for growth in the medium-term will be a lack of credit demand. Many households and companies have realized that they could
go under and they are going to build a buffer...
Nationalism and protectionism will gain in popularity while there is a big risk of regulators going on a rampage (we see a strong risk of this
cyclical ERROR like the commercial banks reserve increase in the 30’s or the VTA hike in Japan in the 90’s here) after doing too little for so many
years…Populism will be a winning strategies for politicians, even more than before…
The current macro data has surprised on the upside with the success of the cash for clunkers schemes around the world (which probably added up
to 4% to US growth in the third quarter), various forms of help for first time home buyers, the socialization of the credit market in the US and
Europe or the credit explosion in China... We continue to see the current improvement as a normal snap back from the worst macro
environment since the 30's. It should not be confounded with a strong recovery.
The traditional swing factors I.e. inventories, residential investments and autos which have historically accounted for almost all the volatility in
GDP are not expected to have the same impact as in the past (and the autos part is probably already behind us, in the US and Europe at least).
Consumption should continue to be a drag in the developed world for some times. Aggregate disposable incomes and net worth evolution and
their influence on savings should be followed carefully as they will be the keys on how quickly the consumption behavior will change.
The fate of the current recovery hangs on the exit strategies for the monetary and fiscal stimuli, how the financial markets will interpret them
and the unavoidable errors which will be made…
Central Banks will have to first give clear guidelines on how they are going first to exit the qualitative phase of their easing now that
markets have normalized. Theyy should do the same for the qquantitative ppart. The QQEs were legitimate
g ((even in our eyes...)
y ) to avoid a total freeze
and collapse of the credit markets and a debt deflation dynamic to develop but not otherwise.
Deflation is still a real risk (we would even say a fact…) and we would thus like to see the quantitative part continuing a bit longer. Central
Banks might even start charging instead of paying interest on the reserves they hold on behalf of the commercial banks. This would encourage
them to pput the moneyy elsewhere into the economy.
y The Swedish Riksbank has started such a scheme and the BoE is discussingg the same...
Expect macro numbers to continue to move in the right direction (and in the next 3-6 months the rate of change is likely to be increasingly positive
as it will be calculated against 12 month old data...) until Q2 2010 at least.
After that… we should remember that we are livingg in the aftermath of the biggest
gg credit bubble in history. y This does not necessarilyy implypy
a double dip as much will depend on the behavior of households and the impact of fiscal and monetary authorities policies or lack of policies...
Europe should be the focus of your attention as there is a high probability that the next “crisis” will have its epicenter there…
In the next few years the world economy will be more volatile than in the 20 years pre-2007… with dramatic consequences on assets
valuation ratios (cheap tomorrow will be much cheaper than what was deemed cheap between 1990-2007)…