Economic Observer 2012-01-09
Before I write one of these Economic Observers, I go back and read previous editions (they are released at the beginning of each quarter).
While more cynical observers might suggest devious intentions on my part, I think it is important to own up to any changes in perspective and be clear about what has changed and why rather than slipping them in unnoticed (which is easy to do when you only address a subject every three months).
Frankly … nothing material has changed in the past year.
--- Europe is a mess … only more so than ever, but at least now it is out in the open.
--- Nothing has been done to clear the system of toxic debt and worthless assets.
--- ALL the major players continue the game of “Kick the Can” with remarkably predictable results.
--- My expectations in the past have been accurate … but my crystal ball still doesn’t have a clock on it so we are waiting for some of the worst of it to happen.
Unlike the majority of 2011 predictions which were all very rosy, we suggested we would muddle through the year but with greater volatility, more social strife, violence and challenges, especially in Europe. The European issues materialized more quickly and progressed much further than I had thought they would in a year but their effect on issues in the U.S. were more muted than anticipated.
U.S. GDP grew from near zero in 2011-Q1 to modest growth in Q3 (revised down to 1.8% annualized). Those numbers are almost the exact definition of muddle along - nothing to cheer about but at least not negative.
The headline unemployment number has been heading down, although that is more of a factor of people dropping out of the labor force than it is of putting people back to work. Today, we employ fewer total people than we did 10 years ago even though our country’s population has increased by several billion. If it were not for the seemingly creative ways we calculate that headline unemployment number, it would be closer to 12 percent than 8.5%. This statistic also ignores the people who are under-employed (another 9-12%).
The other area of interest (to me as a financial planner and) to you as a reader who wants to navigate whatever is coming your way is fiscal balance. Are we saving or spending? We already know that the government is spending way more than it brings in … but how about the private sector?
In 2006, I remember doing a talk in front of a Kiwanis group and telling them that the personal savings rate was below 2%, down from a peak of 12% in the 70’s and early 80’s. With the financial crisis of 2008, the U.S. consumer began to deleverage and save, pushing that savings rate up to 6-7%. Today, we’re back below 4% and heading in the wrong direction.
So we got the muddle along economy I expected and did nothing to change the behavior which led up to this point over the past several years/decades. 2012 will be a foregone conclusion of those choices.
Europe
A year ago in this Economic Observer, I said:
“The biggest economic challenges facing our world will likely originate out of Europe.”
A year later, we have gone through the whole process of (a) denying that Greece is a problem to (b) accepting that Greece is a problem then (c) trying to contain the Greek problem with lots of money, bailouts and drastic (draconian even) austerity measures being imposed on the Greek people. The contagion is NOT over. We have started a similar cycle with Italy and have yet to really let loose the same pestilent issues in Spain, Portugal and very likely France.
While leaders could (and did) throw half a trillion Euro at Greece and Italy, there isn’t enough money in the world to throw at bailing out Spain’s and Portugal’s balance sheets. Another question is, “Will these countries, which already have deep double-digit unemployment as well as severe recession issues, accept the austerity measures that are sure to be part of the “prescription” from the ECB, the EMSF, the Germans or any other entity that is created to “address” this issue?”
Meanwhile, all of Europe is in a recession. Production numbers from the Eurozone are dismal and falling rapidly, even in Europe (German Factory Orders Drop More Than Expected).
What to Expect - More of the same problems, more futile and expensive attempts to fence the contagion, more austerity for countries already in deep recession, more social strife and more violence in the streets. Eventually (and it is very likely to happen in the first half of 2012), the European system will simply break.
The European Union will not look the same at the end of 2012 as it does today. How much collateral damage, violence, human suffering and global economic devastation will come of this process is well beyond my ability to even imagine. It could be orderly, muted and contained … or it could be disorderly and expansive.
The Next U.S. Recession
The ECRI U.S. Recession Prediction has been under pressure as lagging indicators suggest that their recession prediction may be wrong. The ECRI has never called a recession that didn’t happen. Just because lagging indicators haven’t flipped doesn’t mean the prediction is wrong … we’re just not seeing it yet.
ECRI is holding strong to their prediction. There is a contagion in leading indicators that are working against each other like a vicious feedback loop. If anything, that contagion is getting worse.
This is similar to a heart attack case that hasn’t happened yet. The patient eats fat-saturated foods for years. Each single instance is no big deal. They don’t feel any worse after each cheese-burger. They may even feel better (cheese-burgers taste good). But the more fat they consume, the more clogged the arteries get.
There are very few symptoms (if any) until, BANG, one day they have a heart attack. The heart attack leads to other complications even if the doctors can get the heart going and the blood vessel unclogged.
What to Expect - As of this writing, the United States is either in the early stages of a mild recession or about to enter into one. The severity of this recession will depend on two things: (1) Decisions made by European leaders in managing their own problems and (2) Decisions by our own leaders (more below).
The Next Bubble
In the 2011-Q2 Economic Observer, I said:
"As long as extra liquidity is sloshing around in the system, the price of something will be going up. That could be in the form of price inflation on everything (including wages) or just price inflation on certain assets."
QE2 (which ended in June of 2011) bumped up commodity prices, especially oil. When QE2 ended, oil prices dropped precipitously. Late last fall, Bernanke’s Fed teamed up with the ECB to provide liquidity to the European Banking system through the “discount window.” Quite predictably, oil prices and other commodities (like food) steadily have risen throughout the world, but I’m not certain this is the be-all and end-all result of this latest round of banking liquidity.
We haven’t really seen the major flare-up that is the tell-tale sign of a bubble … yet. It could appear in China (where there are serious inflation problems on some things as well as massive deflation in real estate and production). Whatever the final hot-spot ends up being, rest assured it will be as painful for as many people as possible because that is the way markets work.
What to Expect - The consequences of the latest round of liquidity injections haven’t surfaced just yet. Expect to see price spikes in some asset class or other this year. Half a trillion Euro’s in extra liquidity can’t slosh around the system forever without something going awry.
Banking Issues
Still nothing has been done to address the trillions of dollars worth of bad debt on the books of banking institutions throughout the world. Until those debts are resolved (and that means somebody has to accept the loss and write off the debt), the banking system will be stuck on life support - one step from a complete implosion.
Clearing that bad debt will create pain, however. That pain will make 2008 look like a child’s birthday party. Once it has happened, though, the stage will be set for more good investment in solid business and production growth.
What to Expect - Your guess is as good as mine as to how long the big banks (the worst offenders) will keep up the charade. Their hand will get forced - either by the market or by true leaders (if there are any of those left) who demand it. It could take years before that happens, though which would mean a protracted period with limited investment in business and limited growth creating more drag on the economies of the world.
Interest Rates
Interest rates are through the roof for troubled European countries like Greece, Italy and Spain. They will continue to rise for other countries in the region as well.
Meanwhile in the U.S., interest rates are at record lows. If you want to borrow money and qualify (which probably means you aren’t that willing to borrow, however), this is a good time for you as loans are cheap. It is also good news for the U.S. government who is one of the world’s biggest debtors.
Older folks, however, should expect another year of near-zero savings yields as we are stuck in a Zero Interest Rate Policy (ZIRP) environment for the foreseeable future. Someday this will change as the bond vigilantes return to the market and crush the manipulators like the U.S. Fed. When that change happens (and it will), interest rates will move fairly quickly, but I would be very surprised if it happens in the next year.
What to Expect
If U.S. leaders decide to throw everything they have at kicking the can down the road one more time (which is the likely response), the U.S. recession in 2012 will be shallow (provided Europe can remain orderly in addressing their problems) but the recovery severely limited. This would minimize pain in the short run and get a bunch of politicians re-elected. The problem is that it does nothing to address any of the underlying issues. We will continue to be attacked by the same enemies with fewer and less effective weapons to defend ourselves.
If we choose to “hit the reset button” and meet our demons head on, there will be (a lot) more pain in the short run, but a high probability that we can then recover from that pain in a constructive and long-lasting way.
Four years ago, we were faced with a choice - “Car Crash” or “Cancer.” We chose the cancer. Instead of hitting the reset button (car crash - very painful but clears the system), we opted to throw a lot of money at trying to hide toxic debt in the banks and expenses well in excess of what we make. The recovery was far more muted and the system itself is severely compromised by all the “medicine” we’ve ingested so far.
Today we are in worse shape than we were four years ago (or even 10 years ago) with little to no chance to see improvements over the next year or two. Should we decide to hit the reset button today, we may have to endure even more pain than would have been necessary four years ago.
Had we chosen the reset button four years ago, today we would be in the second or third year of a more robust recovery. Rather than being hypersensitive to contagion from Europe and sick with the toxic debt and excess liquidity overloading our system, we would be the strong hand and the strong currency to which others would be flocking for safe haven.
Prescription
The prescription hasn’t changed since the beginning of last year. Following are all tools YOU can use to immunize your own personal situation from some of the disease that will be flowing around you.
--- Watch Cash Flow - Run your own financial ship lean and clean. Contact us for more information on the Cash Flow Hydrant™ system - an easy way to eliminate spending on stuff that doesn’t matter to you.
--- Build Cash Reserves - Put the extra money you’re saving from above into cash reserves. That money will come in handy soon enough.
--- Take Risk Off the Table - Risky assets (like stocks) drop on average 40% during the first parts of a recession. The markets closed relatively even with how they started last year (after one heck of a roller coaster ride). This is no time to be taking on more risk.
--- Be Conscious - Over the next year, you will be faced with numerous important choices. These are not choices you will want to make emotionally or by the seat of your pants. Be alert. Be prepared. Try to be calm.
Real Hope
I am going to close this Economic Observer with something more positive. It is a quote from John Hussman’s weekly blog. If you don’t read Hussman … well … you probably should. Here is what he said last week:
“Instead, our hope is that in 2012, the market will finally "clear," in the sense that bad debt around the world will be recognized as bad and restructured; that overleveraged financials will be taken into receivership instead of forcing austerity on every corner of the global economy in order to make them flush again; that rates of return will rise enough to compensate and encourage saving - and high enough to encourage borrowers and other users of capital to allocate the funds productively. Of course, in order to restructure bad debt, someone has to accept a loss. In order for rates of return to rise, valuations must decline. In short, our hope is for events that will unchain the global economy from an irresponsible past and open the gates toward a prosperous future.”
When the reset button is finally hit (note I said “when” and not “if”), the system will clear and things will get incrementally better. With technology and innovation, our lives on this planet can improve dramatically but that will only happen once we begin to obey some basic laws of economics: Deficits matter. Money can’t be manufactured out of thin air. Bad Debts Can’t Be Called Good Debts.
The game of "Kick the Can" will come to an end. The only question is, “On who’s terms?”
John