Rebel Traders – Analysis Without The Hype

Michael Pento takes a look inside the projections of a “V” shaped recovery, and turns it upside down.

The following article is re-printed for you here with permission from OilPrice.com

Originally published at: http://oilprice.com/article-the-tepee-shaped-recovery.html

The Tepee Shaped Recovery

By Michael Pento

The shape of this economic recovery will not be in a “V”, as many pundits have promulgated, but instead may be the inversion of that letter…which will unfortunately look much more like a tepee. The upcoming downfall will surprise most investors who have been tricked into believing that a government can print and spend their way into prosperity.

Undeniably, there has been a superficial recovery in the economy, which was presaged by a 65% rebound in the S&P 500 since March of 2009. Third quarter GDP was positive—albeit at a subpar and marginal 2.2%—and Q4 of 2009 and Q1 of 2010 should also show positive economic growth as well. But most of that growth will come from an inventory rebuild and not from a sustainable increase in output.

But let me explain why this recovery will severely underperform those of previous recessions.

First we must realize what has previously led the economy out of a recession. It has historically been consumer spending accompanied by a recovery in the housing market.  But we never had a nation-wide bubble in real estate before this previous period. After a bubble bursts, it takes decades before the asset in question can return to its former highs—and that’s without adjusting for inflation. For example, look at the gold market in 1980 and the NASDAQ market in the year 2000. The gold market didn’t return to its nominal high until 2007, some 27 years after its bubble burst. And the NASDAQ is still more than 50% below its former high of 10 years ago. Therefore, if the nature of bubbles also applies to the housing market, we cannot count on real estate to lead the economy out of a recession. Evidence of the continued weakness in housing was displayed by last week’s release of pending existing home sales, which dropped by 16%!

Many economists also believe that the consumer will spend us into a viable recovery. They are mistaken here as well. Household debt as a percentage of GDP was “just” 46% back in 1983—that was the last time the unemployment rate was 10%. Today household debt is 96% of GDP. That’s correct; consumers have more than twice the level of debt as they did during the last serious recession. Can they be counted on to pile on more debt at this juncture? I think not.

But perhaps the most trenchant difference between this era and those of previous recessions is the direction of interest rates. In the early 1980’s, the effective Federal Funds rate was close to 15%  and declined to below 6% by the middle of that same decade, thanks to a precipitous drop in inflation. One cannot underestimate the huge tax cut that was given to investors and the boon transferred to businesses and consumers by having the cost of money plummet in such a short period of time. I would argue that the cost of money and the rate of inflation could and should increase significantly over the next few quarters. But even if I’m wrong, no one can contend that interest rates will provide a tailwind for the economy in 2010 as it did during the early 80’s—the last time unemployment was above 10%.

Finally, in order to believe the economy is on the brink of a lasting recovery we need to see that banks are lending money to the private sector in order to purchase capital goods that are used to create wealth. However, we see the opposite occurring today. Total Loans and Leases at commercial banks have decreased 7.7% from December 2009. The only money banks are lending is to the government. Without capital being extended to small businesses they cannot expand production or hire new employees.

The sad truth is that the real estate market will be in a malaise for years to come. The consumer will not be able to take on and service a substantially increased amount of debt. There will be no relief from falling interest rates or lower inflation and the cost of money may indeed rise despite the Fed’s manipulations. And banks are frozen from lending precisely because the demand from money is down while the compulsion on the part of financial institutions to preserve their capital is overwhelming.

Knowing the truth will enable you to understand that the Fed will not be able to raise rates significantly in 2010. That means that the dollar stands unprotected and will resume its secular decline. Commodities will do well along with foreign stocks. Unfortunately, the rising price of oil and other commodities will put pressure on an already overburdened consumer, who already suffers from stagnant wage and labor growth.

The sooner we face these realities the sooner we can start to deal with them in a legitimate fashion. We can start by defending the value of our currency. Thereby ensuring that the upcoming double-dip recession is not also accompanied by yet more inflation.

Article written by Michael Pento, Senior Market Strategist at Delta Global Advisors for OilPrice.com who focus on Fossil Fuels, Alternative Energy, Metals, Oil Prices and Geopolitics. To find out more visit their website at: http://www.oilprice.com

Highlights of the most recent report from Reis Inc, Real Estate Research -

Andy Xie, whose insights we have often referenced in our chronicles is back with an analysis of the failure of Keynesian economics in Japan on Caijing.

As previously mentioned in two posts, Andy Xie firmly believes in a second dip taking place somewhere next year in Anglo-Saxon economies.

Before delving more ahead, that specific distinction warrants by itself more attention, as to the foundations of the US or British economies. It is true that they have been based on sand in the form of dangerous credit expansion and a housing market bubble. Something similar to what is happening in China, with the addition of a huge bailout that was partially rerouted towards the stock markets and commodity assets. You can read the full article here.

For Xie, exports were one of the major motors of the Japanese economy (not unlike China).

Anyone who doesn’t believe in the harm of a financial bubble but does believe in Keynesian stimulus magic should visit Japan. A likely dip for the Anglo-Saxon economies next year will underscore these truths. The same goes for anyone who thinks China’s latest real estate bubble, asset borrowing and shadow banking system are worthwhile substitutes for real economic growth.

The world including China can learn a lot by looking at what’s happened to Japan, and what’s in store for DPJ. Since Japan’s stock market bubble burst in 1989 and the land market popped in 1992, the LDP government has run up debt equal to nearly 200 percent GDP in hopes of reviving the economy. And its economy has stagnated.

The burst of the global credit bubble in 2008 brought down Japan’s export machine. That was its only hope. Now, of all OECD economies, Japan’s looks most like a depression. Its nominal GDP declined 8 percent in the first quarter 2009 from the year before. Although its economy rebounded a bit in the second quarter, nominal GDP for 2009 is still expected to decline substantially and will likely be lower than in 1993.

Despite the difference in the return on assets between Japan and the US, it might almost instinctively be understood that Japan was mostly basing itself on “real” economy, whereas the US corporations were using financial engineering to achieve the higher return.

U.S. return on asset (ROA) was twice as high as that in Japan. But, in hindsight, higher ROA in the United States was mostly a bubble phenomenon. Much of U.S. corporate profitability was due to financial engineering. In one aspect, the export performance of Japan’s corporate sector has done very well — much better than its U.S. counterpart. Japan’s exports doubled in yen terms between 1993 and 2008, and the sector’s share of GDP nearly doubled to 16 percent from 9 percent, even though the yen remained strong during the period. The performance of Japan’s export sector shows its inefficiencies elsewhere were largely due to shortcomings in the system.

Where it starts getting very interesting, it is in the policies pursued to stimulate recovery in Japan from the 1980’s onwards, after the country fell prey to a burst real estate bubble: rates at zero and… abolition of mark to market! Sounds familiar?

The consequences of running high deficits and trying to maintain the bubbles has been of maintaining a very high cost of living, thus putting a pressure towards limiting the birth rate and ultimately compounding Japanese economic issues.

This strategy was flawed in three aspects. First, even as the corporate sector earns profits to pay down debt, the government’s debt is rising. At best, it is shifting corporate debt to government debt. In reality, government debt has been rising faster than private sector debt has been falling.

Second, economic efficiencies don’t increase in such equilibrium. Existing resources in the zombie sector are essentially unproductive. Bankruptcies improve efficiency by shifting resources from failing to succeeding companies. When rules are changed to stop bankruptcies, efficiency is sacrificed. Worse, incremental resources are sucked up to pay fiscal deficits used to prop up zombie industries. Japan is thus trapped in equilibrium of low productivity.

Third, a long period of stagnation could worsen irreversible social change. A falling birth rate, for example, is one consequence that is wreaking havoc on the Japanese economy. Japan’s post-bubble policy was to let property prices decline gradually. Hence, living costs also declined gradually. On the other hand, the economy stopped growing, which caused income expectations to quickly adjust downward. The combination of high property prices and low income growth rapidly pushed down Japan’s birth rate. As a consequence, Japan’s population is declining two decades after the bubble. The rising burden of caring for the old will lower Japan’s ability to pay for anything else.

Legacy of the failed policies of stimuluses: Japan’s corporate indebteness is of about 180 % of GDP even if the households are “only” leveraged at 69 % of the GDP. Of course, the Government’s debt is one of the highest in the world at 194 % of the GDP (still some way to go for the US before becoming nipponized).

For Andy Xie, the Japanese experience prefigures what will happen to the US next year:

As the global economy is again showing signs of growth in the third quarter, most governments are celebrating the effectiveness of their policies. Yet Japan’s experience forces us to pause: Its economy experienced many such growth bounces over the past two decades, but was unable to sustain any of them. The problem was Japan only used stimulus, not restructuring, to cope with the bursting of its bubble. After the demise of any big bubble, serious structural problems that hamper economic growth remain. Stimulus can only provide short-term support that makes structural reform possible. When policymakers celebrate the short-term impact of stimulus and forget structural reforms, economies slump again. I think the Anglo-Saxon economies will dip again next year.

He sees the only solution in restructuring at the same time as stimulating. Bankruptcy, from that point of view is an essential tool as it refocuses resources on more efficient companies, rather than on the failing companies.

Andy Xie concludes by exploring some avenues and necessary restructuring for China, but in my view, many of his comments could be transposed to the US:

A bubble rises when there is excess money supply. Is the current, excessive monetary growth due to demand or supply? We can argue that point forever. When the former chairman of the U.S. Federal Reserve, Alan Greenspan, said a central bank couldn’t stop a bubble, he meant money demand would rise regardless of interest rates. I disagree. If a central bank targets monetary growth in line with nominal GDP growth, a big bubble can’t happen. Aside from central bank failure, then, the most important microeconomic element in a bubble is the shadow banking system.

Regulators limit what banks can do by imposing capital requirements. The international standard is 8 percent of total assets, but banks can use accounting tricks to minimize their requirements. But a big accounting loophole can lead to disaster. For example, the loose restrictions on off-balance holdings were major factors in the global credit bubble. Most regulators are now tightening accounting rules for capital requirements.

Shadow banking is a less noticed but more important factor in creating bubbles. Most analysts compare it to the hedge fund industry, which provided leverage for financial speculators with little capital. The shadow banking system is much more because industrial firms engaging in financial activities are more important. Entities such as GE Capital and GMAC provided massive leverage to asset markets with little capital. A shadow banking system is essential to a big bubble.

China’s corporate sector increasingly looks like a shadow banking system. It raises funds from banks, through commercial bills or the corporate bond market, and then channels the funds into the land market. The resulting land inflation underwrites corporate profitability and improves their creditworthiness in the short term.