Rodrigo C. Serrano New York, NY Direct 305-510-0181 Email Websites:  


Macro Outlook (Mid- 2012)


July 4, 2012 Table Of Contents (p. #) • Executive Summary (1) • Global Economy/Trade (2) • U.S. Monetary Policy (8) • U.S. Government Policy (11) • Confidence (15) • Inflation (15) • Industrial Production (17) • Consumption/Borrowing (18) • Jobs (19) • Service Industry (20) • Housing (20) -----------------------------------------------Executive Summary Globalization’s dark side has arrived. The global economy is currently held hostage by a political crisis in the Eurozone, critically harming the already weak foundations of the global recovery. Fiscal prescriptions demanded by Germany and other core-countries have led to recessions throughout the periphery, along with increasing nationalism. While last week’s announcement for a euro-wide banking regulator, to be instituted by the end of the year, drew worldwide acclaim and caused a powerful rally in risk markets, the accord is unlikely to eliminate the festering wound threatening our global economy. There’s a dangerously high probability that Europe’s announcement has come too late and that European

officials will find themselves obligated to take very uncomfortable and hurried steps towards fiscal union in the months to come. Meanwhile ongoing austerity in Europe has led to a “larger than expected” slowing in China, as the export-dependent country’s largest client is falling into a deep recession. Chinese officials have instituted policies aimed at both subduing the country’s buoyant real estate market and moderating inflation. With no significant stimulus on tap, I am skeptical that the communist country can withstand an exogenous economic and financial shock emanating from the Eurozone. Finally the Eurozone crisis has begun to affect U.S. consumers and businesses. Confidence and clarity in future growth have diminished. Job creation and business investment have slowed. The national savings rate just hit a 4-month high and is a testament to the growing worry over events transpiring across the Atlantic. We are currently in the midst of a crisis of confidence, which may lead to the selffulfilling prophecy of global recession. The coming year may mark the next disorderly phase (2008 was the first) of what I’ve called the “Global Economic Restructuring” process; which has been the fundamental macro trend to recognize and track over the past few years. Continued

    intervention and manipulation on the part of political and monetary officials have delayed this adjustment and in fact have worsened today’s large imbalances. Indeed, they have created an uncertain environment, damaging confidence for long-term investment. To be sure, government officials will likely continue to intervene in our capital markets should economic conditions continue to deteriorate. These actions may cause bullish shifts in sentiment as well as powerful relief rallies, especially given that investors have grown to embrace central bank intervention as a panacea. However, in the absence of significant fiscal stimulus (both in the U.S. and Europe), monetary authorities may find themselves unable to stop the eventual process of restructuring that needs to take place. The coming years are likely to remain turbulent as China continues on its course to become the “world’s consumer,” as the U.S. was for many decades, while the U.S. and most of Europe retool their economies to feed China’s eventual insatiable consumer demand. There are wildcards in regard to the long-term direction of the global economy however, the most significant being in the presidential election this coming November. Regardless, if world leaders can successfully navigate the treacherous waters of global restructuring over the coming years, eventually today’s seemingly endless period of weak economic performance will lay the foundation for a powerful secular bull market that may last for decades. Until then, investing today will require flexibility, risk management, and a   willingness to embrace the fact that buyand-hold investing has taken a back seat for the time being. Global Economy/Trade Events transpiring in Europe since my last thesis update, roughly 6 months ago, have been generally in line with my expectations. As far back as a year ago, I recognized that Europe was on a path towards political crisis, due to a fermenting currency crisis in the region. The lull in protests across the Eurozone during the winter and spring months dissipated and remonstrations have become more intense as of late. However, contrary to my expectations of no quantitative easing and despite obvious displeasure from the Bundesbank, the ECB’s 2nd long-term refinancing operation in February was perceived as such, improving investor sentiment worldwide in the early months of the year. However, this step did not result in a permanent solution and continued uncertainty has reduced bullish sentiment, affecting the global economy, in particular China. China’s manufacturing sector has now matched the length of contraction seen during the 2008 financial crisis. However, this contraction hasn’t been nearly as acute. Overall, continued weakness in the Asian nation was mostly in line with my expectations of a clouded outlook with significant downside risks. I did, however, underestimate the resiliency of the real estate market. Price depreciation has slowed and has brought bulls out of the woodwork rightfully stating (so far) that China’s important real estate market has finally stabilized.



    Looking ahead, my short-term outlook for global trade in the coming 6 months remains bearish. The probability of a disorderly fragmentation in the Eurozone has increased from 50%, stated in my prior thesis update, to 60 to 80%. Should we have a negative conclusion, there’s a 50 to 80% likelihood of a subsequent hard landing in China due to an acute worldwide financial exogenous shock. All in all, not a pretty picture. Last week’s accord to use the EFSF/ESM to conduct direct bank recapitalizations, setup a region-wide bank regulator, and address the thorny issue of seniority with regard to Spain’s bailout was greeted with much enthusiasm amongst investors. Let me first state that I wholeheartedly agree that this is a big and unexpected step forward towards a fiscal union in Europe and the specter of a financial meltdown in the coming weeks has been reduced. However, the devil lies in the details of the agreement…as always. Direct bank recapitalizations are unlikely to come before 2013. In addition, the aid will come only after European nations relinquish sovereignty of their financial industries to the EU’s new bank supervisor, which is supposed to be formed by the end of the year. Moreover, important details remain missing and implementation risk looms. Next, in today’s headline-driven world, it’s easy to unwittingly focus on the trees and lose sight of the forest. Taking a step back, here’s what I see. First, both the EFSF and the ESM do not have enough resources to combat the crisis, as clearly illustrated in the graphic below created Ray Dalio’s Bridgewater.


Source: Bridgewater – ZeroHedge

While it is possible that a banking license may be granted to the ESM, thereby significantly increasing its capacity, this bullish prospect is becoming increasingly dubious due to my second point below. Patience among Eurozone leaders, and more importantly, their constituencies is running perilously thin. Despite last week’s bullish summit result, negotiations were described as “horrid.” Additionally, major German newspapers lambasted Merkel, announcing that she caved in and relinquished the country’s wealth to bailout profligate periphery-countries. Likewise, lawsuits challenging the constitutionality of the ESM are increasing in frequency. The prospect of a referendum grows with every passing day. Meanwhile, newspaper articles from Greece to the UK have increasingly brought back nefarious memories of Nazism, framing Merkel as a dictator. Granted, many of these publications are left leaning, but looking at recent elections, these messages are clearly resonating the growing displeasure of austerity-racked periphery citizens. After 3  


    the summit, newspapers in Italy, Spain, and France boasted how their leaders were victorious by pushing Merkel into a Uturn. In fact, Italy’s Monti made it a point to claim a “double victory” over Germany, referencing Italy’s win in the 2012 EuroCup. I do not see these as signs of increasing unity in Europe. While last week was a clear step towards fiscal union, the meat of the solution was once again a prescription for a liquidity crisis, not a solvency one. Trade imbalances and austerity policies to correct them look set to continue, depleting financial resources used to attack the symptoms and not the underlying causes of the problem. This means that recessions in the periphery will continue and are likely to worsen, further inflaming nationalistic sentiment. In my prior thesis update, I posed the following question: “Has psyche amongst the periphery citizenry and political spectrum crossed the event horizon into nationalism?” Ironically, piecemeal solutions designed to buy time to set the stage for a United States of Europe are in fact worsening the crisis by allowing more time for nationalistic sentiment, and political parties tapping this powerful dynamic, to gain strength. Third, political rifts between Europe’s top economies are blatant and untenable. A strong political push to relax austerity measures and tap bailout funds has yielded a positive resolution. However, Germany and other core-countries maintain that they will require strict conditionality over dispersed funds. Common sense leads me to disagree with the view that it is politically feasible for Germany to reverse course and grant unconditional bailouts demanded by periphery nations. Inevitably, the high-risk event of a   referendum will occur. Furthermore, French President François Hollande has recently reversed Sarkozy’s law by lowering the retirement age citing “social justice.” This policy goes flatly against the German prescription for the crisis. With increasing economic pressure in the periphery fanning nationalistic sentiment, odds are increasing against Hollande relinquishing the fiscal and financial sovereignty that core-countries mandate. It is clear that policy discord is fatally infecting the political unity desperately needed to combat the crisis. Meanwhile in Italy, we have the new 5-Star Movement gaining momentum as well as the political situation in Greece. In general, these movements are introducing the concept of “odious debt” into the daily vernacular. The Bottom line is that discussions for a fiscal union should have taken place during the go-go years of growth prior to the 2008 crisis, not in the middle of a deep regionwide recession, which has spawned a significant political crisis. Finally, while the prospect of another LTRO always makes for fresh bullish fodder, it is increasingly clear that prior operations worsened the state of Europe’s banking system by infecting banks with toxic sovereign paper. Furthermore with decaying political cooperation, I surmise that a push for another LTRO may well transform Europe’s creeping political crisis between core and periphery-countries to an acute state. Nonetheless, it is very possible, even likely, that officials will again turn to some sort of monetary intervention to avoid a catastrophe, likely resulting in a powerful turn in sentiment, if only temporarily.



    In conclusion, while recent news from Europe’s summit was well received, focusing on this event neglects the larger macro trend of increasing discord within the Eurozone, which I believe will worsen, until it is put to a euro-wide referendum. Until then austerity, recession, and a strengthening of nationalism look set to continue, depressing sentiment and increasing an already high likelihood of the self-fulfilling prophecy of disorderly fragmentation. European officials must move quicker. Indeed, while Germany may be getting flak from government officials around the globe, it is France who holds the key to a positive resolution. If Hollande can embrace relinquishing France’s fiscal and financial sovereignty, other peripherycountries would likely follow suit. All Germany has been asking for the entire time is for periphery-countries, which are in need of bailout funds, to sign on the dotted line to confirm their commitment to a true European fiscal union. In China it’s becoming clear that an orderly rebalancing from an export to consumer-based economy will be very difficult with continued uncertainty in Europe. This leads me to increase the probability of a hard landing from 40-70% to 50-80% should the Eurozone fragment; however, I am a little more optimistic for a soft-landing if there’s a positive solution and am slightly lowering my probability of a hard-landing (sans a negative catalyst from Europe) from 30-50% to 20-50%. Interestingly despite the ever-increasing danger of a negative catalyst in the Eurozone and continued sluggishness of the U.S. consumer, Chinese officials still use the term “fine-tuning” to describe their macro adjustments to the economy. Use of such a term implies that officials are not   immediately pondering the introduction a significant stimulus package. I see this two ways. First from a long-term bullish view, officials are finally focusing on improving the country’s economic structure by focusing more on consumption, an important requirement for “global economic restructuring.” Furthermore high prices have made real estate out of reach for the majority of the country’s citizens. It would be imprudent to initiate another stimulus package, which could result in a leg higher for the country’s resilient property market, leading to increased inequality. A second, more bearish, way to look at the current scenario can be done using a simple analogy. China is mowing the lawn, sweeping the porch, and wiping the windows while the house next door is burning down. They should be getting the hoses ready to put out a likely fire in their own home due to plenty of dangerous embers flying from the blaze. I believe officials have found fiscal and macroeconomic religion at the wrong time. There’s an elevated probability that they are behind the curve with regard to fastmoving events in Europe, a slowing global economy, as well as the country’s own slowdown in fixed-asset investment, which comprises roughly 45% of GDP as of 2010 according to the World Bank. Figure 1 on the following page shows that exports to the EU and U.S. account for roughly 40% of China’s total exports. Figure 2 demonstrates that China’s total exports comprise roughly 40% of its GDP according to the U.S. Bureau of Economic Analysis and Economist Intelligence Unit.





Figure 1 – Source:

Figure 2 – Source:



    Indeed one can see that China’s export economy is under increasing stress due to a deteriorating global economy by looking at the recent performance of the Renminbi. Romney had (and continues) to bluntly state that China is a currency manipulator. He recently stated that embracing a more aggressive stance towards China was the centerpiece of his economic policy. I also covered how U.S. politicians needed to practice stern patience, that China was taking the necessary steps and to give them time. Taking aggressive protectionist policy actions would be the last thing the global economy needs at this point. Since then my fears have been somewhat alleviated by Romney’s position to move aggressively and open up more foreign markets for US exports. However, seeking confrontation with a future superpower is not in the best interests of global long-term prosperity. China remains significantly underdeveloped and the future untapped demand of its consumers will eventually be the impetus of global long-term growth in the decades to come. It is in our best interests to have an integral part in this long-term development. What has recently caught my attention is the growing tension in the South China Sea, which involves territorial disputes between China and Malaysia, Thailand, Brunei, and the Philippines. It will be particularly important for the current U.S. administration as well as the next president to carefully defuse this potentially negative catalyst. Obviously any resulting negative event may spark a stronger wave of tension and protectionism at precisely the wrong time. I’ll be keeping an eye out for further developments here.


Source: WSJ

If growth for approximately 16% of China’s GDP is compromised due to slowing growth in Europe and the U.S.; there’s an elevated probability of a financial exogenous shock stemming from the EU; and growth in gross fixed-asset investment, which accounts for 45% of GDP, is falling; it puzzles me that officials would continue to use the phase “finetuning.” Obviously if there was an exogenous financial shock in Europe, China would likely respond with another hefty stimulus package. I only hope that any stimulus is primarily aimed at long-term reform to accelerate the global restructuring process. Protectionism In my prior thesis update, I mentioned how “the clouds of protectionism were gathering and could pose a large negative risk for global trade in the quarters ahead.” I covered how presidential candidate Mitt



    Middle East I don’t pretend to be an expert on Middle Eastern affairs; however, events there have me very concerned. My primary conclusion is that tensions are increasing, not decreasing. Israel continues to openly discuss the military option against Iran. Iran doesn’t seem to be backing down, despite an oil embargo initiated by most of the Western world. Meanwhile, Syria is at the precipice of a civil war, if not already in one. Tensions between the country and Turkey are at a boiling point and Russia stands ready to assist the Syrians with military weapons to the chagrin of the West. Needless to say, any negative surprise from this region would add another negative dimension to an already jittery global backdrop. Over the Long-Term (1+ yrs) I remain a bullish fellow in the long-term. The future of the global economy lies in China. The country is in the slow process of preparing for period of sustainable expansion. If we were faced with a negative market environment in the coming quarters, I’m sure one could find plenty of diamonds in the rough in regard to U.S. manufacturing and transportation companies. I continue to believe that China’s stock market has bottomed and it is currently in the retesting phase. Since my previous thesis update wildcards, such as the advent of protectionism as well as conflict rocking the Middle East, have increased in probability. It is important to remain alert for any developments along these fronts. Finally, continued quantitative easing (QE) from central banks, especially our Fed, could set the stage for a period of worldwide vulnerability to inflation once the global restructuring process is near completion. U.S. Monetary Policy While many investors expected QE3 to be unleashed by the Fed sometime during the beginning of the year, I wasn’t betting the house on it. In the past 6 months, rising 5 and 10-yr breakevens further reduced my expectations for any sort of QE. Surprisingly though, the Fed extended its Twist operation until the end of the year, despite breakevens remaining at elevated levels. Perhaps they felt that plunging gas prices were a green light for more intervention. In the short-term, the Fed stands ready to initiate QE3 should we have a negative resolution in the Eurozone. Excluding this negative scenario, I believe the case for more quantitative easing is strengthening. However, the approaching U.S. elections will likely complicate matters, as any QE would be seen as politically motivated. Therefore the outlook for QE, absent a negative surprise from Europe is clouded, but with a bullish hue. The following pages contain a compilation of the current bullish and bearish points for quantitative easing.




    • (QE Bullish): The current FOMC is dominated by doves, most likely supporting further easing measures should economic activity continue to underperform. Circled members represent this year’s FOMC.


Source: Reuters–Absent are Jeremy Stein & Jerome Powell; early indications reflect dovish tendencies

(QE Bullish): Though an inexact science, comparing forecasts of the prior 2 FOMC forecasts for GDP, the unemployment rate, and inflation versus the latest prognoses released roughly 2 weeks ago show a decline in inflation and GDP expectations along with an increase in the unemployment rate. Fed officials see slower growth and falling inflation, a good recipe for additional monetary accommodation in the months to come should economic growth continue to underperform expectations.





Source: Calculated Risk Blog

(QE Slightly Bullish): Market expectations of inflation, such as 5 and 10-yr breakevens are mostly neutral. However, falling rates of inflation at the producer level and sub-50 ISM Manufacturing Survey’s Prices Received subcomponent increasingly support the case for further easing. (QE Neutral): The Conference Board shows consumer inflation expectations are falling (though remain historically elevated), while University of Michigan’s survey shows expectations trickling lower. (QE Neutral): The year over year rate for CPI has been declining, reflecting falling food and gas prices. However Core-CPI, arguably longer-term in nature, has remained elevated just above the Fed’s year over year target rate, at 2.3% vs. 2.0%. Rising rents, due to a lack of multi-family dwellings, will likely keep Core-CPI sticky to the upside. (QE Bearish): While I mentioned that gas prices accounted for a fall in the headline CPI rate, they are still high by historical standards. Furthermore, the prospect of conflict in the Middle East is always a bullish factor for oil. I recently categorized conflict in the region as a bearish wildcard in the global outlook. It would be shortsighted if the FOMC wasn’t accounting for this unpredictable factor. By glancing at my prior outlooks, one can construe my negative long-term view of continued monetary accommodation. From my prior outlook: “I remain adamant that this policy is creating a platform for

The topic I’ve begun to focus on is should the Fed institute its third major QE operation since 2008 what happens after that?



    powerful unintended consequences over the longer-term, should the global economy avoid the long-term risk of protectionism. These policies only serve to distort capital markets and disrupt the process of actively allocating capital to produce real economic growth. The progressing global economic restructuring is slowly opening the Pandora’s box of these policies.” I’ve recently seen an interesting development in this regard. None other than the Bank for International Settlements, what some refer to as the Central Bank of central banks has recently expressed its concern for rates remaining so low for so long. “With nominal interest rates staying as low as they can go and central bank balance sheets continuing to expand, risks are surely building up.” Furthermore, prominent analysts such as Pimco’s Mohammed El-Erian, have drawn attention to this growing unease, but with a new wrinkle. From a recent FT Alphaville article, “Pimco’s Mohammed El-Erian was the most recent high profile name to throw light on the issue. Commenting on the Fed’s latest decision to extend Operation Twist last week, El-Erian explicitly stated that lacking fiscal support, solitary Fed activism would only alter the functioning of markets, contaminate price discovery and distort capital allocation.” Funny how yours truly said exactly that half a year ago. So what does this all mean? First, there is a growing belief among respected analysts that QE is causing more harm than good, that ultra-loose monetary policy has not been the panacea that many expected when the Fed began its first QE program in 2008. Moreover, loose monetary accommodation has resulted in increased inflationary problems in emerging markets. But, perhaps the most important implication of these concerns is that without fiscal stimulus, which is unlikely forthcoming over the short-term, and if the Fed is forced into a QE3 by the negative catalyst in the Eurozone, the Fed’s aura of invincibility (i.e. “Don’t fight the Fed”) may be at serious risk. Notice that in every other instance in which the Fed announced some sort of extraordinary monetary easing (QE, Twist, etc.), U.S. growth was either firmly positive or there was some sort of fiscal stimulus flowing through the economy, whether it originate here or abroad. This time around, the largest economic bloc in the world is in recession (likely entering a deep recession), China is “fine–tuning” macroeconomic policy, and the U.S. economy is nearing stall speed with no fiscal stimulus on the horizon.
* For readers familiar with the layout of my prior outlooks, I have moved my U.S. dollar forecast to my market outlook.


U.S. Government Policy Since 2010 I’ve identified a theme, which I call “Political Frugality” where the specter of overblown government deficits would make it politically difficult to pass any large-scale stimulus package. Political deadlock has continued, leading to a lack of leadership from Washington as both parties jockey for position leading up to the presidential election in November. Persistent consumer deleveraging continues to expose the private sector to an exogenous shock, such as a Eurozone breakup and/or a Chinese hard landing.



    From a bullish perspective, the economy has maintained positive momentum in spite of the fading effects of the 2009 stimulus, which I posed would be a challenge. Surprisingly, a weaker global economy during the 1st half of the year didn’t profoundly affect economic activity at home, until recently. Furthermore and inline with my expectations, political debate has begun in order to reverse automatic spending cuts set to begin in 2013; in addition, Congress voted to extend the payroll tax cuts as well as unemployment benefits. Unfortunately and surprisingly, the extension of unemployment benefits included a reduction of the number of weeks of extended aid and effectively made it more difficult for states to qualify for the maximum aid. Reports have surfaced of the long-term jobless losing their extended benefits. Looking ahead over the short to mediumterm, I sense that sentiment towards austerity is likely to weaken should economic activity continued to deteriorate. Unfortunately due to the oncoming November elections it is unlikely that fiscal stimulus will be forthcoming unless catastrophe hits Europe, causing a recession at home. As I stated in my prior update, “My fear lies in the need for decisive action from government officials to step in with fiscal stimulus in case of a downside surprise from Europe or China.” While many (including myself) may call it fiscal profligacy, the likely extension (partial at least) of the Bush tax cuts as well as the delay of automatic spending cuts should be seen as a short to mediumterm positive. The economy, as vulnerable as it is and with significant uncertainty in   Europe cannot afford to take a 0.40% hit to yearly GDP as shown in the following graph.


Source: ZeroHedge: Goldman Sachs


The fact that government officials are negotiating to avoid at least partial fiscal contraction in 2013 tells me that they understand that the private sector remains fragile. Continued historically loose fiscal policy would act to offset weak spending growth as deleveraging continues. I’ll be focused on news of continued progress on this front. Note however that a financial exogenous shock from the Eurozone would overwhelm the positive effects of current loose fiscal policy. Before you cringe at the notion that I believe that loose fiscal policy is good for the economy, I want to clarify that kicking the can down the road is undoubtedly a negative long-term prescription. However, I believe that finding fiscal religion now is unadvisable. Finding it in the midst of a strong recovery and in turn paring back spending, “countercyclical fiscal policies” as Keynes supported, is how fiscal policy should be handled. Looking over the longer-term, I believe that government officials will eventually


    address the structural causes of this prolonged period of economic fragility. We may get a giant jobs-based stimulus, including a government sponsored nationwide university system to retool displaced workers as well as large investments in the nation’s infrastructure, alternative energy, and exports. Unfortunately, we’ll likely need a crisis to get lawmakers to unite as they did in 2008 to pass a program of this magnitude. Protectionism Beginning 2012, I identified a potential negative trend of the growing tide against continued globalization. Indeed, the World Economic Forum has also expressed this concern. The weak foundation of our global economy has resulted in a period of uneven and uncertain growth as well as growing inequality. As a consequence, trade frictions have increased as politicians remain under pressure to create jobs at home. I see the rise of protectionism as a symptom of an idiosyncratic problem with global trade not covered by typical economic analysis. To begin, protectionist policies impede the flow of capital, reducing economic profit and subsequent residual funds for continued investment. It is well understood that global trade increases total economic production and wealth, as capital is allowed to flow freely to the highest wealth creating activities. Unfortunately with highly unequal wage gaps between countries, private capital flow and investment has been decidedly one sided. Investment in China has increased significantly, while the U.S. remains struggling to produce strong job growth. Ideally, it would be more prudent   to set up a system of “Regional Globalization.” In this system, the majority of trade would occur freely but within countries with similar cost/wage structures. The resources of a country would determine what output could be produced at a competitive advantage. Regrettably, our highly globalized marketplace is currently working to achieve equilibrium between low-wage emerging markets (experiencing wage growth) and high-wage developed countries (with stagnant wages). However it is pivotal to understand that China is taking matters more seriously. They understand that an export-centric model isn’t sustainable. Indeed one need only look at China’s most recent “5-Year Plan”: “Some important initiatives of the economic rebalancing theme in the 12th FYP include a notional GDP growth rate target of 7 percent, promoting consumption over investments and exports, closing the income gap through minimum wage hikes and increased social safety nets, and a range of energy efficiency targets.” It is very important that U.S. officials continue to practice stern patience so that China may devote more resources to change course, instead of worrying about a pending trade war, which would sink their economy. This has been the source of my concern as Romney has made strong statements about actions he will take against China if elected. While it is prudent to act sternly so that they feel obligated to move quicker in their efforts, acting in a threatening manner would clearly be counterproductive.



    As I expected, when looking at the Intrade charts below, tracking the probability of recession and Obama’s chances of reelection, one can clearly see that Obama’s fate is tied to the economy.


If one’s higher probability scenario calls further economic turbulence, like mine, it would be prudent to begin wondering what life would be like under a Romney presidency in regard to global trade. Similar to souring business sentiment in Europe for a market friendly solution and consumer sentiment during the U.S. fiscal standoff in 2011, sentiment regarding uncertainty in global trade could result in stalled expansion plans and consequently lower economic growth worldwide. On the bright side Romney has somewhat alleviated my fears by committing himself towards aggressively opening up other export markets. But as I said before, cooperation with an eventual superpower, if not militarily, then consumer demand-wise, is important to eventually seek the long-term benefits of a new world economy. That’s why I’ll be carefully covering events transpiring in the South China Sea. If issues there are not handled in a responsible and fair manner, they may further increase the risk of protectionism.   14  

    Confidence Confidence has become one of the more important factors to watch. I began to see consumer confidence indicators as a true measure of actual improvement on Main Street. Since 2009, markets have significantly recovered on an improving global outlook; however, consumer confidence has remained lackluster. Inline with my expectations, confidence improved as the job market strengthened. Conversely, confidence has begun to decline as the specter of a Eurozone breakup fills the newswires. Confidence is an integral ingredient for a budding economic positive feedback loop. Continued uncertainty is breaking the current fragile one and the prospect of a self-fulfilling prophecy of global recession is becoming dangerously real. It’s also important to see if unresolved issues regarding the oncoming “Fiscal Cliff” begin to act as a headwind as well. On the bright side, plunging gas prices and a stabilizing real estate market are positive and strengthening points. However, the wave of uncertainty due to the aforementioned bearish factors currently dominates the landscape.


Inflation As in my prior outlook, I remain convinced that there are notable harmful risks in the Eurozone and China over the short to medium-term. Negative developments here would trigger a surprise global deflationary episode, similar to the one in 2008. I still worry about deflation instead of inflation. However, I did not account for our current disinflationary environment (see the 2nd scenario below), which represents continued optimism towards a market friendly solution in Europe and/or a possible soft-landing in China (manufacturing data is not showing a sector falling out of bed). Below are my updated scenarios: 1. Deflation: Eurozone Fragmentation / China Hard landing (Avg. Probability = 50-75%): A global recession would likely occur. Deflation would make a vicious comeback. Along with falling global growth, another U.S. recession could result in a wave of restructured and/or eliminated debt. This scenario could also result in the dreaded Japanese mindset of deflationary anticipation. Consequently falling consumer demand would sap job creation. Fed would continue QE; however, the key to recovery from this scenario would be fiscal stimulus. 2. Disinflation: Eurozone Fragmentation/China Soft landing or Eurozone Fiscal Compact/China Hard landing (Ongoing --- Avg. Probability of end result = 25-50%): A disinflationary environment would ensue if one of the two major global risks had a negative resolution. An uneven global recovery would negatively affect commodities and a chronically weak U.S. consumer would translate to a stronger bargaining power of buyers versus suppliers. However, this scenario would serve as a significant step



    forward in the global restructuring process as well as eliminate growth-sapping debt, possibly resulting in a solid cyclical bull opportunity in medium to long-term. 3. Uncomfortable Inflation: Eurozone Fiscal Compact/China Soft landing (Probability = 5-10%): The U.S. economy would stabilize then resume its recovery. Commodity prices would increase, fueled by a rebound in global growth. Additionally, wage equalization between China and the U.S. would carry on. Higher wages in China would see more companies moving operations back to the U.S. (Manufacturing Renaissance) or smaller emerging markets to cut down on costs. For years, U.S. businesses have been trimming fat. To increase production, long-term capital projects would need to take place. Improving economic activity in benefiting nations would lead to bottlenecks in manufacturing sectors. It’ll be important to keep an eye on capacity utilization (80 mark = budding inflationary pressure).


Due to the Fed’s myopic policies (QE, Twist, etc), these secular trends would result in a period of persistently high inflation, likely harming economic growth as well as the middle class and retiring baby-boomers with fixed incomes. This sequence of events would also be a developing secular bearish headwind for the U.S. Treasury market (Top?). The Fed would eventually be forced to raise interest rates, thus semi-capping the recovery’s potential. An example of this environment occurred in 2011 (absent Fed rate increases). Higher commodity prices led to increasing inflation and interest rates during the first half of 2011; however, the weak U.S. consumer was unable to shoulder these higher costs and by mid-year the recovery was in jeopardy. I eventually see this scenario occurring over the long-term, absent a bearish catalyst arresting global trade. That is why the Fed must stop extraordinary loosing now.



    Industrial Production Over the past 6 months, the manufacturing sector has led the U.S. economic recovery and has outperformed my expectations of a muddle through scenario. However, downside risks that I covered in my prior update are beginning to affect business confidence. Declining confidence is currently poisoning prospects of a continuing recovery and must be immediately reversed. Indeed the sector is in critical danger of contracting – the latest reading of the ISM manufacturing gauge signaled its first contraction reading in almost 3 years. I had been wary of expectations for continued strong growth given persistent weakness in backlogs coupled with continued uncertainty with global growth. Monitoring the latter is of upmost importance when figuring the sector’s short to medium-term trajectory.


Despite my increasing bearishness over the short to medium term, I remain bullish over the sector’s long-term prospects, once again assuming the bullish scenario of relatively little protectionism. Future sustainable consumer-led growth from China and other emerging markets would fuel a manufacturing renaissance in the U.S. While I don’t believe this scenario is knocking at our door, it’s progressively getting closer. On the other hand, if protectionist policies were further embraced by political leaders, the outlook for manufacturing would be clouded but with upside potential (fracking, shale gas, coal, etc.). The sector would become a significant job creator; however, from an investment view, margins would be continually under pressure due to eventual inflation (see capacity utilization figure on prior page)



    Consumption / Borrowing The consumer has trudged forward, exhibiting the demeanor of a salmon headed back to its birthplace far upstream. Over the past 6 months, the economy has been in a fragile positive feedback loop with just enough consumer-demand improving business confidence, thus leading to job creation. However, the near-term risk posed by slowing global growth is depressing confidence and stimulating what until now has been a controlled “paradox of thrift” (deleveraging). I am cautiously bearish. Consumption growth is suffering significant damage; the national savings rate is at a 4-month high, possibly beginning a sustained uptrend. While gas prices have been declining markedly in the past month, uncertainty in the direction of the global economy is beginning to dominate consumer sentiment (beware of increasing uncertainty in regard to upcoming “fiscal cliff”). Indeed, declining purchases of durable goods, such as automobiles, is a shot across the bow that further ambiguity in Europe is starting to rock the boat. A solution must be found soon to arrest declining confidence.


As in my prior thesis update I still remain concerned of conditions in the Middle East. A negative surprise from this region could cause a spike in oil prices as well as

add a new dimension of uncertainty to an already tense geopolitical stage. Medium to long-term, consumption growth is likely to remain weak as the consumer 18  


    deleveraging process continues and wage growth remains stagnant. From a bullish standpoint, we have come a long way in the process and are likely past its midpoint. Ironically though, Fed-induced lower interest rates are prolonging the malaise by denying retirees higher and safer returns, leading them to save more present income. Two giant bubbles have decimated retirement plans over the past decade (again due to the Fed). Baby-boomers paid a dear price if they took excessive savings risk by tapping the “home ATM machine” and spending far beyond their means. Then, with the onset of the property bust, they became exposed to elevated financial market risk, as drops in portfolio values has now obligated victims to alter their expected retirement lifestyle and/ or delay retirement. Eventually once the consumer recovers, he/she could be faced with persistently high commodity prices as well as increasing interest rates (see scenario 3 in my “Inflation” outlook). In case of a negative surprise in the Eurozone or China, we may see the passage of more fiscal stimulus in the medium-term (6 months out to roughly 1 year) as government officials act to stem the damage of a second recession. Simply extending Bush-tax cuts or delaying automatic spending cuts wouldn’t be enough. However, should a fiscal stimulus package be passed, along with likely continued loose monetary policy, the prospect of a mirror image of 2009 could gain credibility. Jobs The labor market continues its slow but vulnerable recovery, as the fragile positive   feedback loop persists. Indeed, I am impressed at its resiliency. However, due to increased uncertainty with regard to the Eurozone and China, businesses are beginning to pull in their horns. I am cautiously bearish on the expectation for further job creation as long as confidence is not restored. Europe must find a solution. Referring to an analogy that I used in my 2011 outlook to explain the labor market: “the pre-born baby must be put back into the incubator soon.” Should Europe convince investors that its latest announcement is a solid step in the right direction, then confidence would return and the labor market would recover. Longer-term, the feasibility of any selfsustaining economic recovery depends on a healthy job market. Substantial and consistent job creation would be a precursor of rising real wages and solidifying consumption growth. However, we remain in a “chicken–or–egg” scenario. Before, the use of credit served as a sparkplug for consumption growth, leading to job creation, and ultimately creating a strong to positive feedback loop. This dynamic has been damaged, but is healing. The recovery from the 2001 recession was built on a faulty foundation (no pun intended). Rising home values and careless lending standards increased the supply of credit (home ATM), producing artificial demand. Once the housing bubble popped, credit dried up and construction activity collapsed; we had a semi-permanent reduction in demand growth. As a result, structural unemployment became a stark characteristic of the 2007-2009 recession. This characteristic is set to linger as a persistent headwind until consumer deleveraging as well as global economic



    restructuring (China = consumer economy) both enter their end phase, reducing longterm uncertainty. It may also end if there’s significant progress on emerging technologies, such as fracking, an expansion in the shale gas industry, or a jobs-based stimulus package from Congress. If I had a kid, I’d be guiding him/her towards learning science or engineering. Service Sector The service sector accounts for 80 to 90% of the US economy. Its performance tracked by the ISM’s Non-Manufacturing index has surpassed my expectations. In my prior thesis update I covered how slowing backlogs as well as new orders had turned me cautious on the sector. While I still believed that the sector’s growth was sustainable, absent an exogenous shock, its strong run in the early months of 2012 (6month average = 55.46) was a pleasant surprise. However, my cautiousness remains. While I still believe that growth in the sector is self-sustaining, creeping uncertainty towards the global outlook risks critically damaging its short to medium-term growth prospects. There’s a high likelihood that a negative event from Europe or China would tip this important sector of the economy back into contraction. Medium to long-term, lack of substantial end–demand growth keep hiring activity at a low level, proliferating tepid end–demand growth; all in all, this sector will be hard– pressed to find any strong impetus for solid growth. On the bullish end, the deleveraging process has likely passed its midpoint; which combined with a structurally improved global economy, will lead to sustainable growth over the longterm.


Housing Nationally, home prices have double-dipped. However, this latest decline has been less forceful than the initial drop beginning in 2006 and as varied greatly in intensity between cities. As I stated in my prior outlook, a recovery in home prices will increasingly depend on local conditions. Markets, such as Miami, have recovered much quicker due to their uniqueness. For example, Miami has lots of ocean front property and is considered the gateway to Latin America. Real estate activity has largely consisted of Latin American investors. On the bright side, construction activity has clearly bottomed. High demand for rental properties is spurring investment in multifamily real estate. This will act as a steady tailwind for job creation. Looking at the bigger picture, we are still faced with a large supply of homes (shadow inventory). Despite increased optimism due to recent good news in regard to home sales, which I correctly forecast, I am less sanguine than many housing bulls who proclaim that the sector has turned the corner and is on the verge of a comeback. Yes, I agree that the sector is turning a corner, however, the recovery will consistently underwhelm due to a myriad of   20  

    reasons. For starters, demand has clearly stabilized, but remains tepid when analyzing year over year rates in the Mortgage Bankers Association’s purchase index.


Second, here’s a chart that puts into perspective the amount of inventory sitting on the sidelines. It will likely take a couple of years at least to absorb most of it.

Source: CoreLogic



    Third, let’s not forget that the U.S. economy is in danger of falling back into another recession if Europe cannot put its house in order or if China’s economic growth surprises to the downside. Another recession would lead to higher defaults, foreclosures, and consequently a strengthening downward trend in prices. Fourth, over the longer-term, price appreciation may face the strengthening trend of higher interest rates, making homeownership less affordable (see scenario 3 in my inflation outlook). Don’t get me wrong, I’m all for a housing recovery. However, recent optimism for sustainable price increases over the coming year seems misplaced. Housing will continue to recover; however, progress will be glacial. From a sentiment standpoint, I remain unconvinced that prices have hit a secular low. The asset class isn’t universally hated yet, except Detroit; I’d be buying up blocks there now in anticipation of a manufacturing renaissance in the years to come. (Next Thesis Update: Early January 2013)




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