Tuesday, January 22, 2008

It's All About Fundamentals, Again

I had written this for posting tomorrow, but with today's developments (Fed cut by an emergency 75 bp) it is more timely to post it today.

List of relevant rates, as of today:

Fed Funds: 3.50%
3m T-bills: 2.50%
2y T-note: 2.05%
5y T-bond: 2.65%

What is the fixed income market saying? Don't bet on a fast recovery.


As global financial markets gyrate, it is a challenge to keep our eyes dispassionately fixed on the economic fundamentals. Yet, we must.

Here are the key points:
  • The global recovery after 2001 was based on: (a) debt-financed household consumption, (b) debt-financed asset appreciation, and (c) the sharp rise in energy and resource prices, which created huge wealth effects in producer countries.
  • The economic growth of BRICs was derivative, i.e. it was a result of (a) and (b) above, and served to further enhance (c).
  • Ultimately, therefore, the whole structure is anchored on the excess consumption of a few hundred million westerners (US and EU), who could spend far above their earned income because they borrowed so easily and cheaply.
Let's examine the last point further, i.e. borrowing by western households:
  • Household borrowing in the US and EU was ramped up when dollar and euro interest rates collapsed to multi-decade lows following the 2000-01 recession and the 9/11 events.
  • Lenders came from: (a) savings-rich Japan looking for higher rates than available in ZIRP-yen, a.k.a. the carry trade and (b) BRICs and resource exporters that could not, or would not, spend their earnings within their own economies. This created what Secretary Paulson has previously described as a "savings glut".
  • A series of financial "innovations" spread credit risk and exposure wider than ever and greatly weakened lending standards.
Let's now examine and interpret present conditions:
  • The US sub-prime crisis is merely the first step of wider credit troubles in the West. The weakest borrowers went under the fastest; next come highly leveraged corporates, speculative commercial real estate and companies with excess capacity, built in anticipation of continuous good times.
  • Vendor financing of western consumers by China and resource exporters was a blind misallocation of capital that resulted in bubbles. Instead of buying western securities, they should have invested their money in domestic social services to raise living standards widely (this is particularly true for China and Russia*). They acted as providers of concentrated, speculative "margin" money to western consumers and they thus share in the blame for the bubbles.
How are things going to proceed from here? What follows is my personal opinion which, as all views of the future, should be taken with properly-sized doses of scepticism (jumbo-pack recommended).
  • Western consumers will revert to spending within their means. It is possible that they will cut even further, in order to repair their overstretched household balance sheets. Saving rates will rise in the US and EU.
  • Fiscal policy "boost" initiatives that are based solely on tax cuts/rebates will be proven ineffective, as the bulk of the money will be saved instead of spent.
  • The BRIC economies will suffer from slowdowns induced by overcapacity and bad business loans.
  • Credit crunch and risk aversion will spread to more sectors and more economies - it will become a wider global phenomenon.
  • Interest rate cuts will bring western economies closer to ZIRP and liquidity holes, instead of inducing credit expansion and consumer-lead growth.
  • We will see significant further deflation in asset prices, and may even see bouts of deflation for consumer goods, brought upon by excess capacity.
  • Commodity prices may decline, particularly where marginal demand is directly tied to robust economic growth conditions (energy, metals, etc.).
In the days, weeks and months to come it may become very tempting to misinterpret the temporary gyrations of share indices, thinking them guides to future economic activity. I believe times are changing, back to when real economic fundamentals determine asset and commodity prices instead of the other way around. The cart is going back behind the horse, where it properly belongs.

We should keep our eyes fixed on the real economy "horse", instead of the market "cart". Some economists and policy setters had become very lazy of late, thinking the Dow told all. It doesn't, and it's high time they started earning their keep honestly, once again...


(*) In the case of the Gulf emirates this was admittedly difficult because of their small domestic economies. How many indoor ski centers can one build in the desert?


  1. Hell,

    Great post today. Accords exactly with my own understanding and expectations of what has happened and what will likely be the consequences going forward.

    You said:

    Fiscal policy "boost" initiatives that are based solely on tax cuts/rebates will be proven ineffective, as the bulk of the money will be saved instead of spent.

    I would just add:

    Or used to pay off debt.

  2. ...as the bulk of the money will be saved instead of spent.

    This would be something new for the average American then, it seems. And the things (prices) are going, and depending, it might be spent after all -- e.g. on gas and food.

  3. Hi,

    You say deflation is likely but surely if the Fed cuts severely wont it further weaken the dollar resulting in inflation of energy and commodities. i.e stagflation?

  4. anon @ 7:38 PM,

    if you compare long-run commodity prices and changes in dollar, the correlation is not that tight; it is not such a mechanical relation as some apparently believe.

    the more recent run in prices has had more to do with asset reallocation strategies than real fundamentals, which is to say that these prices are also subject to debt deflation.

    while it has recovered somewhat, oil, for example, fell over 4% this morning and not because of fx or unknowns but forced sales. there are finance driven cross-assest class trades.

    back to long-run. a look at average annual GDP (U.S. or global) since 1980 v. financial markets can provide a picture of how severly imbalanced the system has become.
    Or, we have had asset price inflation well outstripping growth for decades, which could even be called 'stagflation'.

    this is in process of ending not beginning.
    price has been stretched far too far from value.
    fast or slow, fictitious capital is in process of being destroyed.
    question then becomes whether a very weak real economy can survive the spiral.

  5. hello,

    quick question if the author can help. will FED cutting rate to 0% help real estate? when will real estate bottom in your opinion

  6. Real estate is about location. The metrocoastal service industry centers will lose population to the flyover central resource and manufacturing areas as we lose the ability to import and have to dig it up, smelt it, machine it, and assemble it ourselves.
    Buy mobile home courts in Ohio, Kentucky, etc, preferably next to coal mines and factories.

  7. Thanks for another thought provoking post. And I'm sorry, but what is BRIC?

  8. BRIC = Brazil, Russia, India, China. The major emerging/developing (to a western standard) markets.

  9. Beautifully succinct exposition of points with which I completely agree.

    Some years ago Richard Koo (then Chief Economist at Nomura) wrote a book "The Balance Sheet Recession" which explained the inability of Japan to reflate as having been due to both businesses and individuals there having gone into balance sheet repair mode -- so no credit-worthy entity to which the banks might care to lend money had any interest in taking on more debt, no matter how low the interest rate.

    I think it can, and will, happen here.

    The consequences of a reversion of the US saving rate to 8% or more for our enormously overbuilt retail and goods-distribution sectors, and for the manufacturing sectors of the Asian exporters, will be severe.

  10. I think you have one of the best sources of information available and am truly grateful for all that i have learned.

    however, if i were in a position to do something about the impending "crisis" (meaning the govt), i believe would choose the least painful path out of this mess. Just print more money to pay for all of the interest rate cuts and economic stimulus, etc etc. FDR is considered a hero for doing this in the past. No one wants any major disasters as you describe. At least consider adding this to your list.

    "Fiscal policy "boost" initiatives that are based solely on tax cuts/rebates will be proven ineffective, as the bulk of the money will be saved instead of spent."

    Teaching old dogs (Starbucks drinking, SUVing, big screen TVing, in big house-ing, private schooling, expensive vacationing, entitlement-ing baby boomers) new tricks overnight? I would be very very surprised.

    No nothing about econimics, but enjoy the entertainment

  11. A great "back-to-basic" post.

    Tracking the most severe capital mis-allocations in the BRIC world could be rewarding at this stage.

    But of course, since US and a couple of EC countries were not even able to properly track their own mortgage financing system - the MOST basic financial item in the world of finance, what chances have we to get timely financial information on BRIC industrial overcapacities. Below zero.

    I basically believe that ANY reduction in int'l container traffic will be a red signal for the over-extended China exporting engines. You blogged on that subject in the past, did you?

    What "down-to-facts" can we use to assess these overcapacities? Have you any fair indicators on international container traffic? Should we track Taiwan performance as the proverbial "canary in the coal mine"?

    I believe we will get the figures after the crash... I alas mean the Asian crash.

    It's now far too late to expect the salvatory changes in yen and yuan rates that could have sweeten the come time period. A hard over-capacity one à la nineeenth century!

    The int'l economy is running with limited "social security" belts. Such as the ones we built in Europe to deal with the crises that socially bled it in the past. As a responsible alternative to marxism as well, by the way.

    In case of a credit crunch such as the one we have - with the US consumption engine on the brake and China growth potentially grinding to halt, I do not expect anything but fairly brutal.

    A la nineteenth century european-style. Those kind of crisis gave birth to marxism. What are China and the US left to invent?

  12. Dear Francois,

    You can track container traffic in the US by looking at the CA ports of LA, Oakland, San Diego, plus the port of Newark, NJ. Look for inbound loaded data. They show weakness, as you said.

    Spot bulk dry cargo rates have also come down fast from the bubble highs (-41%).

    As for "the next thing" in politics I see "Green" and sustainable growth as the next movements.


  13. Great post Hell. I'm sure you're right about where things are headed. If for no other reason than banks retrenching from the previous levels of lending and households purging themselves of debt,consumption in the US is headed significantly lower.

    However, what role do you see the US dollar playing in food and energy prices?

    I think the wildcard in the deflationary scenario you have described is the worlds acceptance of the dollar as a store of value and the world's reserve. The actions of the Fed yesterday have further undermined confidence in the US as steward of the dollar's future. Which is why it would be foolhardy at this point to assume the inflationary pressures seen already from these core items(food and energy),will abate meaningfully. Particularly if crude production continues declining. US households are in for a very difficult period indeed.

  14. H.

    Well done!

    Brian P

  15. Personally, just as someone that is a saver, I find it hard to imagine that US and UK consumers, having to borrow, as you state, to maintain their lifestyle, will suddenly find huge incentive to purchase Treasury notes while the FED lowers rates. Which not only lowers retrun, but the value of the dollars the notes are paid in. Negative return overall, for certain.

    I'm betting they did what I did the last 5 years while rates were a disincentive to place in US savings accounts or T-bills, and invest in foreign assets gaining value.

    But, that's my crystal ball, everyone's got their own. Mine looked into Jimmy Roger's ball.

  16. As you've said, the money will not be saved.

    It won't be spent, either.

    Most will use it to pay down junk debt.

    Reality will set in, eventually, and the American consumer will HAVE to change his ways.

    But, I don't think that happens right away. From the top to the bottom, we've all gotten very good at fooling ourselves.

    The current way of life is not sustainable.

    I've been in MANY homes of those who are "poor," and MOST of them were loaded to the gills with "stuff." These were people who were receiving government assistance of some kind. Their basements and attics and garages contained more items than I have in mine. .. how much more crap can we convince ourselves that we need?