TFTF

Deflationary Warning Signs

November 9, 2001

Let's look at the huge amount of data that we had this week. (Thanks to Wayne Anderson in my office who gathered a few hundred pages of articles for me to read while I was out.)

I had dinner with fellow analyst Greg Weldon this last Sunday in New Jersey. Watching the scores of wild swans and Canadian geese on a tranquil ocean side pond, we reflected about what Greg calls the "deflation tsunami" that is sweeping the world, which is anything BUT tranquil.

Deflation has been a long time theme of this letter. It is why I have been so bullish on bonds for years. I first wrote in the fall of 1998 that we are "approaching a period of deflation", as a summary of an article. We are now there. Let's look at the evidence, which is mounting each month.

Just the Facts

*The Labor Department reported that prices paid to US producers last month dropped 1.6%, the biggest decline ever. Part of that was the drop in energy prices, but even without energy, prices still dropped .5%.

*So far this year, inflation at the wholesale level has been declining at an annual rate of .8% (WSJ). Consumer prices are still rising at an annual rate of over 2%, but even they are coming down, and I expect them to continue to do so. We may see a period of outright annual CPI deflation.

*The Commerce Department said last week that its favored measure of inflation - the price index for gross domestic purchases, or prices paid by US residents - fell by 0.3% in the third quarter, a sharp reversal from the 1.3% increase in the second quarter and the first quarterly decline in 40 years.

*Bank loans are down. Many readers ask where is all the money going that the Fed is creating? Part of the answer is that banks are taking money out of the system. Growth in commercial and industrial loans, which reflects bank lending to small businesses, has contracted for the last three consecutive months. Large firms, which issue "commercial paper" have seen these markets dry up, as non-financial commercial paper (non-financial institutions like banks or insurance) is down almost 40% if I read the chart correctly. Either they can't get the money or don't want it. Either way, that is neutralizing the money creation activity of the Fed. That is deflationary, any way you read it. It is also called pushing on a string.

* Import prices are down 2.4% and US export prices are down another 2% as well

*Prices are down everywhere in the world, as manufacturers try to use price to hold up sales. Just as the US auto industry offers 0% financing to get sales, foreign companies do whatever they can to get dollars. That means they generally compete on price.

If capacity utilization is 75.5% in the US, what do you think it is in the rest of the world? This much excess manufacturing capacity is a huge deflationary force. By the way, "In the past, when the capacity utilization rate was 75.5%-as it is now-the jobless rate was around 9%. I don't see this happening, but I wouldn't be surprised if it jumps to 6% before the end of the year, and to 7% by the spring. During previous recessions, both the capacity utilization rate and the employment rate fell together. This time, they are out of sync. So, if the job market deteriorates significantly in coming months, that could make the recession deeper and longer than widely expected. This scenario could test the bullish convictions of the farsighted visionaries." (Dr. Ed Yardeni) I agree. Unemployment also brings its own special deflationary forces with it.

*Inflation is dropping all over world. There are too many countries to mention which have seen worse numbers than the ones I quote above. I could do a whole newsletter on how ugly the numbers are getting. Europe will be in recession this quarter, and probably was last quarter, or very close to it.

Japanese Head Case

* And then there is Japan. Basket-case Japan. Weldon talks about Japan officialdom doing a special type of dance called the Ostrich because they have their heads buried in the sand. I am not sure that they don't have their heads buried in a darker realm than sand.

I get energized about their incompetence only because they could do some serious damage to any US recovery potential. I have a relatively high degree of confidence in US businesses to figure out how to survive and grow. On the surface, if all we had to face was US economic weakness, I would be quite optimistic about the future 12 months from now.

However, I must acknowledge we are part of a global economy. If Japan exports its deflation, which it is now doing, it could keep the world in recession a lot longer than 12 months. It could even make it much worse. Frankly, with all the potential bad news and problems, Japan is #1 on my worry list.

Official Japanese deflation is 1.4%, and they expect the economy to contract at a nominal rate of 2.3%. Only a few months ago, the government boldly claimed they would grow at 1.7% (which I said would not happen). The scary part is the Japanese reaction to this new "fact". The Prime Minister actually said that the government reaction should be to spend $25 billion in various construction projects to stimulate the economy. That was it. The lack of response is staggering. The US Fed and the government, with a situation far less severe, is on the verge of a panic response, and Japan wants to spend $25 billion.

Weldon points out: "In other words ... the Japanese government is saying that the deflationary spiral will WORSEN over the next five months, while they stand around and debate what to do about it."

I will summarize scores of pages Weldon has written in the past few weeks on Japan.

The Japanese Bank index has collapsed over 50% in the last six months. Many banks are down 90% from their highs. Many regional banks, reflecting the local economy, are on the verge of collapse.

There is clearly something going on in banking circles. You can watch the stock trading patterns to tell that those in the "know" are dumping Japanese bank stocks. We were promised last spring that by October that a special committee would make recommendations as to what to do about the problem of non-performing Japanese bank loans. We got nothing. Basically, it now appears that many Japanese banks are in even worse condition than merely insolvent, and that the amount of the problem is huge.

The Japanese economy will not recover until they deal with their systemic bank problems, and the government keeps putting it off.

Finally, there is one more puzzling thing, which I have seen nowhere else but in Weldon's analysis. The Japanese have bought $45 billion in US bonds in the last four weeks. But the yen is holding steady. BY all rights, it should have dropped. Japanese officials have made it clear they want to weaken the yen against the dollar. Then why hasn't the yen gone down?

Japanese businesses and individuals must be recalling assets from everywhere they can. Smart Japanese money is bailing out of banks and out of the yen. They are converting whatever they can get their hands on and turning it into dollars.

Why is the Japanese government stalling on fixing their banks? I don't want to seem conspiratorial, but it seems like the crony-ridden government is waiting until all the big money (their sponsors) has a chance to position itself before they pull the plug on the banks and the smaller investors.

I do not think the Japanese are stupid. They know of their problems better than I. They know they have to deal with them, yet they do not. The Japanese government is not concerned with the problems they could cause the rest of the world. They are concerned with making sure the insider money is properly positioned.

Here is their problem. They have banks which have made loans to companies which are not solvent and not profitable, and need zero interest loans to maintain themselves. They have made the loans based on assets such as land and stock which are not valued at current prices, but at much higher prices. Some loan portfolios in real estate may have collapsed by as much as 805 or more. If they ever cleanse the system, the price of land and stocks in Japan will drop even further. Deflation will increase at a rapid rate.

What can they do? They must inflate their currency. But, as Gary North points out, the Japanese are first and foremost bureaucrats. They will want to "manage" the crisis. Secondly, they want above all else to "save face".

They are and will continue to contend they are lowering the value of the yen in order to help their export economy. The bank of Japan will soon start to "merge" banks, and say they are doing so to strengthen the economy.

This creates significant problems as they are the second largest economy in the world. They make huge loans and finance much of the world, especially Asian business. If their currency suffers, their ability to make loans dissipates.

The total value of Japanese assets - stocks, real estate, businesses -- will shrink. This is a huge deflationary pull on the world.

To use a crude analogy, the effect on the world would be similar to the effect on the US if all the assets in Texas and California suddenly shrunk by 20%. (That is not an economic analysis - just an illustration. Do not quote that figure as analysis.)

Will the rest of the world go along with this? In a word, yes. The US will make a few noises, but so much of Japanese money will be in US bonds, helping push down our rates, that we will sit still. The rest of the G-7 countries will be afraid to force Japanese banks to adhere to banking agreements on balance sheets and true solvency because they know if the Japanese banks really marked their loans to market value, it would essentially force the nation to declare bankruptcy. That would be a worldwide Depression.

So, we watch and hope. As Greg Weldon notes above, it seems inexplicable that Japan is not trying to re-inflate their currency. It is in their best interest, as it is in the best interest of the rest of the world. I can only think they will eventually do so, and as much as I hate to think it, it is possible they are waiting so that as much yen from their insiders as possible can get into dollars.

It is a serious game of chicken with the world economy. If they wait too long, it will make our recession longer than 12 months.

Just for the Record

*Total unemployment is the highest it has been since 1983. If unemployment is on target to go to 7%, then there are another 1,000,000 employees who will see pink slips within the next 6 months. Watch consumer confidence, which rose slightly this week, to fall dramatically.

*An odd statistic which is somewhat bullish. Anthony Gambocorta, chief investment officer of Preswick Capital Management notes that the forward P/E ratio of the S&P 500 is currently 25. But when you take out the technology companies from that average, it is only 19. That tells me the NASDAQ is still at major risk, and that the rest of the index, while vulnerable, is probably not facing another 30% drop, even in the face of a serious recession. The overall index, however, could still be in for a rough ride. But it also means that when we do see the bottom, there will be some good values.

*Crude oil jumped back up to $22 when OPEC announced cuts in production. After winter is over and the world economy is still weak in the spring, I predict (with only a little trepidation) that OPEC members will cheat and that prices will drop below $20 again.

*The NAPM non-manufacturing (service sector) index dropped to 40.6 from 50 last month. This represents 80% of the economy, and clearly shows a serious decline in the vital service sector. The drop is 60% worse than analysts expected.

*The Bank of England and the Central Bank of Europe cut their rates (finally) by 50 basis points. They did so because industrial production declined dramatically.

* Morgan Stanley notes that Detroit is now slashing production to prepare tof the inevitable sales "payback" that will follow as sales incentives expire. As they point out, it is production, not sales, that matter for the economy and for profits. Dave Greenlaw estimates that these cuts are massive enough to cut 1.7% from fourth quarter GDP in and of themselves.

I could go on, but you get the picture. Things are going to get worse before they get better. That is why I think that those of you still holding tech stocks should look at this latest rally as a gift. Bonds seem to still be the place to be. They have certainly been good to us this year.

*************

Last week's e-letter touched off more comments, both positive and negative, than any letter in recent memory. That surprised me somewhat. Analyzing the comments, I realize I need to clarify some of my points. A few of you did not realize I had my tongue firmly planted in my cheek with some of my comments. Just for the record, I enjoy reading from those of you who disagree with me. It is my responsibility as a writer to be clear, but calling me names is really over the edge. I am basically a sensitive kind of guy with a thin skin. Really.

#1. I did not say that the economy was going to rebound quickly because the Treasury is no longer issuing 30 year bonds. I clearly said the economy would be worse in the fourth quarter, and that we would likely see a full 12 months of recession, barring the global economy making the situation worse.

The economic news for the remainder of this year is going to be ugly. The news is always ugly at the beginning of recessions. Just as I was highlighting bad news this time last year and saying the economy would fall into recession (which it did), it is now time to begin to look for reasons that the economy could rebound. The economy will rebound at some point. The real question is when and how much?

#2. I said the Treasury move was brilliant. I did not make it clear that I thought it was brilliant in much the same way you admire the skill of a con man on the streets of New York shuffling the cups and hiding the pea. By now, long term readers should know that I am basically an economic libertarian. The less government the better, in my view.

The country would be better off if the government was on a cash basis and did not have any bonds. (Except for self-liquidating infrastructure investments like roads - although many libertarians would assert that even roads should be private. I do not go that far.)

The country is better off without the government competing for long term money. It will help lower long term rates to businesses, home owners and other borrowers. I wrote last year that the surpluses would have the affect of lowering long term interest rates over time. That is what Greenspan was counting on. After 9/11, the surpluses went away. Greenspan had to act to lower long term rates.

In a perfect world (or at least my perfect world) the government would not have been in the long term market to begin with. I am not writing philosophy in this letter. I try to write about the economy and markets. The effect of the Treasury move is beneficial to the economy, and that is good for all of us. I also wrote I expect them to re-institute the 30 year bond in the future. This is the shell game in action.

I should have pointed out that this smacks of desperation on the part of the Fed, as numerous other commentators did last week, including Greg Weldon and Steve Roach who is the chief economist for Morgan Stanley.

This was the Fed's surprise ace in the hole. They can and will cut another 50 basis points or so, but they are getting close to zero. Other than re-inflating the economy, which they and the rest of the world will try to do, they are getting close to the end of their bullets.

The economy will eventually rebound because of the hard work of a lot of people and businesses taking risk. The Fed is as much a part of the problem as it is part of the solution.

#3. We are following a number of indicators which should help us determine when that turn-around approaches. I call them the Three Amigos, as they generally turn up about the time the economy starts to turn around and the stock market hits bottom. These are capacity utilization, the NAPM Index (The National Association of Purchasing Managers Index) and junk bonds. In my view, long term investors are better off investing when the economic tide is rising and getting out of the market when it is receding. It is still receding.

There is an economic logic behind each of the Three Amigos signaling a bottom, which I have written about several times. When each of these indicators rise in concert for several months, then we can move back into equities with some confidence.

From my investment point of view, it does not matter whether the recession is 12 months or 18 months or 24months. It will end at some point. The Three Amigos will hopefully tell us when. I am not trying to trade this market (at least in this letter). I am trying to read the economic tides and ride the financial waves.

Ironically, the worse things get, the closer we are to a bottom, and the more bullish we should become. But the Three Amigos are there to temper our enthusiasm. Just because things get to 20 year lows does not mean they cannot go lower.

Thanks for listening.

**********

I will be doing a special Accredited Investor E-letter early next week. If you are an accredited investor ($1,000,000 net worth) and would like to receive this free letter, email me back and I will send you the application form. I would love to make this available to everyone, but the rules are such that I can only talk about certain things to those with high net worth. I don't make the rules, but I do follow them.

Finally, don't let all the current problems overly concern you. Keep your perspective. Remember, we are closer to The Bottom than we were at this time last year. At my age, it seems like time passes so quickly, that it will be just around the corner. If you are sitting at home worrying about the future, stop it. Enjoy life. God has been very good to us, and on average we enjoy a lifestyle that is far above 99% seen by anyone in history and 94% of those who are on the globe now. We are a blessed people.

Your really looking forward to the weekend and glad to be home analyst,

John Mauldin

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