TFTF

Simple Deflation

January 11, 2002

Last week's 2002 Forecast laid out the clear cut case that deflation would be the dominant economic force in the first part of 2002. I took pains not to use any recent data, trying to make the case on long-term economic patterns. I have always felt it is dangerous to use weekly data to make long-term forecasts.

As the months roll along, we will look at the weekly data that comes out to either confirm my belief or force me to change. Also, we will be looking for signs of returning inflation and a weakening dollar, both of which could have a major impact on the outlook for long term bonds and the stock market.

(First, I will be in Phoenix, New York, Philadelphia, Boca Raton and California in the coming weeks. See details at the end of this e-letter if you would like to meet.)

Today, we are going to look at a slew of reports. Each report will be like a thread, weaving a tapestry. When we are finished, we will stand back and see what kind of picture it is showing us.

First, let's look at a few headlines which crossed my computer this week:

Subject: Yen Plunges as Officials Signal Japan Won't Try To Stem Decline -

Subject: Japan plays its final card in battle to revive growth - (London Financial Times): "Until a couple of months ago it was the strategy that dared not speak its name. Recently, however, Japanese policy makers have been quite brazen about seeking a weaker yen. With interest rates at zero and credit rating agencies breathing down its neck about the government deficit, Japan has exhausted all other conventional macroeconomic techniques to revive the economy. But economists say it is doubtful that the last-resort policy of yen depreciation will succeed where other techniques have failed."

Subject: Yen's fall risks Malaysia devaluation - (BBC): "Malaysia's Prime Minister Mahathir Mohamad has said his country may be forced to devalue the ringgit, if the Japanese yen continues to decline in value."

Subject: Korea Says It May Takes Measures to Counter Yen's Drop - (Bloomberg): "South Korea signaled it may take measures to weaken its currency as the yen's decline threatens Korean exports. 'The weaker yen creates a burden for our exporters,' Finance Minister Jin Nyum said

I could quote articles from other Asian countries with much the same tone. I have been documenting for over a year the "competitive devaluation" that Asian countries are committing. It is now going to get serious. My friend Greg Weldon uses the analogy of a NASCAR-type Devaluation Raceway, and notes that the green flag is out and all cars are at full throttle.

Subject: Japan seen on the road to default - (Japan Times)

"The negative net worth of the Japanese banking system is somewhere above the yen equivalent of $1 trillion. When the banking system collapses . . . the Bank of Japan will need to inject at least $1 trillion into the banks to protect depositors from losses," says the latest issue of the Economic Outlook report by the American Enterprise Institute for Public Policy Research.

"Such systems will probably result in nationalization of Japan's banking system, since the government will have underwritten its solvency," it says. As a result of the issuance of a huge amount of government securities, Japan's public debt will jump immediately by about 15%, and the surge in liquidity will cause Japan's currency and bonds to collapse , the report says.

"Japan's deflation and debt crisis now constitute systemic risk to the global economy," it says. Japan needs "a massive direct injection of liquidity into the economy -- not into the moribund banking system -- through the direct purchase of foreign bonds, corporate bonds and land by the BOJ," the report says.

I should point out that the American Enterprise Institute is normally a very sober group of analysts. You don't often read such dire doom and gloom from them. They are essentially saying that over the next few years, the Yen is likely to get much worse than the 150 I predicted last week. Given the stance of their neighbors, that they will match any devaluation, it does NOT bode well for the US or the world. The Japanese will not take the recommended step of direct injection of liquidity, but will do everything they can to save their banks and save face. Count on it. This will also be the worst thing they could do as far as the US economy is concerned. (more below)

Prices Continue to Deflate

Let's look at another thread.

Subject: US December Import Prices Fall 0.9% - Fell Record 8.9% in 2001 - (Bloomberg): "Prices of goods imported into the U.S. fell in December and declined more in 2001 than at any time on record , as the recession weakened demand."

Subject: 2001 Decline in PPI biggest since 1986 - (Bloomberg): "For the year, the price index fell 1.8% after rising 3.6% in 2000.

Subject: European PPI will be down at least 1.5% (Wledon):

Last week I noted that the CPI (Consumer Price Index) has been essentially flat for six months, down from the already low area of 2% during the first part of the year.

What is happening? Deflation, pure and simple. First clue, let's look at falling import prices. I cannot find statistical surveys ( I looked and hope someone has the data somewhere for me to look at), but I would bet you a dollar against a donut that the bulk of the import price decline was due to Asian imports. If you look at the Asian price export data I have quoted over the last six months, you will note that many Asian countries are getting 20% or less for their goods in terms of dollars. That is a huge one year swing.

That 8.9% drop in prices does two things. It lowers our consumer prices directly and indirectly lowers them as US producers are forced to charge less to compete. That means everyone makes less profits.

Example: the combined market share for General Motors, Ford and Chrysler has shrunk to 63% from 71% over the last four years. That means lower profits, lost jobs and slower growth as these firms purchase less from US manufacturers. Just today Ford announced they would close 5 plants and lay-off 35,000 people, on top of the declines they have already announced. They do this in an effort to stay profitable, but it comes at enormous job cost to US workers.

One of my favorite analysts, Bill Gross of PIMCO, in an article fretting about the direction of the dollar wrote these words. I couldn't say it better, so we read his:

"Now, in the midst of a global recession, our 'strong dollar' policy may be just what the doctor ordered for our competitors to revive faster than the good ol' U.S. of A. Not only has Japan gotten the message that a weaker currency is better but, Asia as a block may soon pile on the devaluation band wagon as a way to survive and ultimately thrive in this era of slim pickens. 'Competitive devals' were tried in the 1930s and went under the name of 'beggar thy neighbor' policies.

"That they cannot work collectively is indisputable, except for the monetary stimulation that usually accompanies them. Selectively, however, it is possible to beggar your neighbor and we are being beggared right and left these days. When the Swiss Central Bank proclaims that it no longer wants the Swiss Franc to be viewed as a safe haven currency, you know the world is turning topsy-turvy."

I highlighted the phrase: "they cannot work collectively" because that is the crux of the issue. Everyone in Asia is trying to make them work collectively against the US, as the initial headlines in this e-letter demonstrate.

Et Tu, Switzerland?

It seems that European Central Bankers would like a somewhat stronger Euro, which would be fine by me. We need some countries to show some sanity and stop this competitive devaluation. Competitive devaluation on the scale it is being practiced today will lead to further deflationary presures.

But now, as I read the above from Gross about the Swiss wanting to see their currency weaken, it reminded me of a quote I read in a recent Greg Weldon letter. (He writes 3-4 a day, so it is sometimes hard to remember exactly which one.) But I looked and found it:

"Competitive Currency Depreciation: From Asia, to Europe, to South America, green flag waving can be seen. Today's "track" is in Switzerland, where the Swiss National Bank has made it's displeasure with the CHF strength against the EUR well known. One of the most outspoken members is Bruno Gehrig. Note his latest comments:

"I would argue that given the current cyclical environment, a somewhat stronger Euro (against the CHF) would be a helpful element, in our own economic environment. You could always fix the exchange rate somewhere. You can always create enough means to achieve a desired level.."

"WOW," continues Greg, "yet another sign that some central bank thinking has mutated, and is swinging towards belief that at least SOME "inflation" is needed."

Let me read that again. It seems to indicate the SWISS might be thinking about devaluing their currency! I remember in the 80's when low paying Swiss Annuities were sold as the paragon of stability. Investors suffered the low yields in order to get a piece of the economic rock that everyone considered the Swiss to be.

Let's carry the race track analogy further. "Where," we might ask, "is the Red, White and Blue #1 car?" Scanning the track, we find it in the pit area, being re-fueled. If you have ever watched a race car come into the pit, you see the pit crew frantically changing tires and re-fueling. They use a high pressure pump and a big nozzle to literally force the fuel into the tank.

Looking closer, we see the leader of the pit crew. He looks familiar, with odd glasses. In fact, pit boss Alan Greenspan is directing the crew to use new high octane fuel. But the engine is using the fuel almost as fast as they put it in.

Why can we increase the money supply at such huge rates as we have done this past year, and especially the last few months? Why can't our economic tires find traction?

It is because of the "beggar thy neighbor" policies (mentioned above) of other countries. They are exporting their deflation to us, and at a dramatic rate.

Greenspan is trying to "re-inflate" the economy, just like the Swiss want to, but he has a problem. Normally, his efforts would mean a lower dollar. That is part of the ebb and flow of currency valuations. But today, the dollar is the reserve currency of the world. As fast as he prints it, other nations are buying it. Either that, or it goes into the current "Son of Bubble" stock market .

If he prints it too fast, bringing back inflation, the world would lose faith and the dollar could drop like a rock. It could lead us into a serious world recession. Print it too slow and we have deflation, a slow economy and a very weak recovery. The trick is too find the level that is "just right".

The problem is that the "just right" level of today's massive money supply growth will create more problem's tomorrow. But is seems the central banker's credo is "sufficient unto the day is the evil thereof" so we will worry about tomorrow's evil tomorrow. Toay's evil is deflation.

The implications for our portfolios are obvious. That is why we will be watching the dollar and inflation very closely this year. But right now, the picture is clear. The threads are weaving a picture in deflationary green.

Something Vicious This Way Comes

I am writing a book on hedge funds, and am currently working on the chapter which will make the case that Absolute Return investments as represented by some hedge fund styles should do much better over the next decade than the average mutual fund. In doing the research, I had the chance to go back to my August 29 issue of last year. I re-read Jeremy Grantham's market predictions in Barron's which I quoted at length. Grantham manages $22 billion and is one of the sharpest analysts on this planet. His predictions were right on target. The interesting thing is that he called the recent rise in the market but then he says:

"...even if the first good quarter is the first quarter of 2002, it should be anticipated any day. The bad news is that there is almost no way this could flow through to earnings. Earnings themselves are a lagging indicator. The capital spending cycle is very important to profits, and it is in full-scale retreat. However low interest rates go, who is going to build a plant that they don't need? No one. So capital spending continues down and corporate earnings are still under pressure.

"If the market were to rally to the top end of my range -- up 20% on a knee-jerk, oh-it-is-all-over, whoopee! -- reaction, the best that would happen to earnings is they'd be flat to slightly off. [He hit the S&P at 20% on the nose! - JM] The market would approach its old high with a substantially higher P/E, because earnings would still be down more than 20%. So instead of 33 times earnings, you'd see the S&P priced in the high 30s or 40 times earnings. The economic recovery will be quite short, two or three quarters, and weak. And then people will get a whiff of the fact that GNP is going to settle back down into a 1.5% range again, because of the capital-spending bust. Finally the negative savings rate will begin to move up, and that will impact top-line growth. The market is no longer in its old game. But this will not destroy the economy. I am not a big bear on the economy at all."

Q: You could have fooled us.

A: Earnings will be weak and sometime in the middle of next year, or even earlier, we'll get a whiff that things aren't as strong as we thought. With the market at 40 times earnings, "the next leg [down] will be more vicious."

He said then what more and more analysts are saying today. J. P. Morgan analyst Tom Van Leuven now thinks earnings in 2002 will not grow at all. He sees the S&P at 950 based upon his forecasts.

"In a note to clients that rattled financial markets, Morgan Stanley chief economist Stephen Roach raised the prospect of a second leg to the current downturn that could send the economy back into reverse after just single quarter of growth. That is sharply at odds with the consensus forecast for a rebound that would begin by sometime in the second quarter and possibly sooner.

Roach warned Monday that five of the past six recessions have included "false starts" of economic growth that were followed by another quarter or more of contraction, and he said that it was likely the current downturn could follow the same pattern.

"Yes, the U.S. economy now seems poised for positive growth in (the first quarter) - an outcome that on the surface would seem to signal the end of recession," Roach said in his note. "But following on the tendency of five of the past six recessions, I suspect this pattern could well be reversed with a double dip commencing by springtime."

In an interview, Roach said there was a two-out-of-three chance that a positive GDP figure in the current quarter could be followed by two more quarters of negative GDP, meaning the recovery would not begin until the fourth quarter. (MSNBC)

Then why are so many analysts so optimistic? As I read them, they are primarily making assumptions about a recovery based upon how previous recoveries in the economy developed. They assume consumer spending will pick up soon, and that roaring profits are around the corner. The "consensus" opinion on tech stock profit growth in 2002 is 46%! The primary reason they assume things will pick up is because "they always have".

But previous recessions were mostly caused by inventory build-ups and inflation. That is not the case this time. This recession is caused by over-capacity and deflation. These are much harder problems to "fix".

Housing Beginning to Weaken

The Meyers Group is a well known consulting firm for the housing industry. They issue a closely watched weekly housing report. As long as I have been reading them, they try to be upbeat, at least trying to find something good even about bad news. This week they had difficulty being optimists, as they write:

"The job market continues to erode, and though rates of job losses and unemployment varied across regions, all the regions showed rising unemployment in December. These job losses led to further declines into negative territory in the national Demand/Supply [of houses for sale] and Employment/Permit ratios, indicating that the current level of housing production far exceeds the amount justified by employment growth. To date, low mortgage rates and less restrictive financing options have allowed the homebuilding industry to thrive in light of poor economic conditions. However, housing market activity often lags downturns in economic conditions, leading us to believe we are now entering a transitory period in which housing indicators will begin to reflect new economic realities at the local level. (emphasis mine)

This was reflected in Greenspan's speech today. His speech was bearish, and a large part of the reason was his worry about housing and mortgage rates.

All in all, between deflation, lackluster capital spending, slow or no growth in consumer spending, a weaker housing market it is much more likely we see a continued weakness in corporate profits.

If Jeremy Grantham continues to be right, investors should become aware of this soon, and become dis-enchanted with the stock market. He says the next leg down in the stock market will be "vicious". Most readers think they have already experienced vicious, and would like a little more kindly market.

But past bear markets are replete with examples of significant bear market rallies followed by even more significant drops. I continue to expect a test of the September lows.

It would not surprise me to see this next low coincide with the real bottom in the economy. I still think we will see a second half recovery to "growth", but that it will be very weak at the beginning.

I am still long bonds and suggest staying out of the stock market, except for value stocks of solid companies with favorable P/E ratios.

Come Fly With Me

I will be in Phoenix on Monday January 14 speaking at the IIR Annual Endowment and Foundations conference speaking on the assigned topic: "State of the Economy: Assessing the Current Economic Environment". I will be in New York and Philadelphia on January 21 and 22, and Boca Raton January 27-30 for the Global Alternative Investment Management conference. I will be speaking on Monday at lunch on the topic: The Fallacy of Modern Portfolio Theory. I would love to meet with clients and prospective clients on any of these trips. I am planning a trip to California in mid-February.

It is a busy time of the year for me. Most of the above trips are to meet with new or current money managers upon behalf of clients. (I am essentially a manager of managers) At the beginning of the year, I like to "touch base", so my travel schedule gets hectic.

I will be taking a day off on February 1. I have twin daughters (they are from Korea and look like beautiful porcelain dolls) who are juniors in high school. Both have been nominated for their high school homecoming court, and Dad gets to join in some of the fun, mostly from a distance, as Dad's of teenage daughter's should be seen and not heard. But I am more than a little proud. Now if only I can lose another 5 pounds so I can get into my tux.

Your Living on Slim-Fast Analyst,

John Mauldin

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