Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.
GLOBAL / U.S. ECONOMY
It is likely that U.S. GDP will have contracted 5% from its peak in November 2007 and the end of
the first quarter in 2009. This means the majority of industries will experience a meaningful decline
in sales revenue, which will require a reduction in production, in order to keep production in balance
with falling sales. As production is dialed down, capacity usage declines, and excess capacity
develops. Keep in mind that the increase in excess capacity is taking place in many industries all
over the world. Since every major industrial economy is in a serious recession, global trade is
collapsing. This is not only bad for the U.S., Japan, Britain, Germany, and other members of the EU,
it is also painful for the emerging economies (China, India, Brazil, South Korea, etc.) that have
benefited from the very countries that are now sliding deeper into recession. When Japan went
through its version of the ‘troubles’ in the 1990’s, the rest of the world was doing alright. That’s
certainly not the case today. Globalization has caused the synchronization of economic activity between trading partners to increase, which has led the monetary policy of various central banks to more closely follow each other. A year ago investors were being urged to shift more of their
investments to foreign markets, since the rest of world was going to decouple from a slowing U.S.
economy. Didn’t turn out that way. Foreign markets tanked, as economies everywhere hit the skids.
A decline in sales will pressure profits, and many firms around the world will be forced to make
some tough choices on capital investments, willingness to cut prices to garner revenue and protect
market share, and staffing levels. Companies will try to determine how long the current level of
excess capacity will last. The deceleration of the past four months has been breathtaking in its speed
and scope, and there is no proverbial light at the end of the economic tunnel just yet in most
countries. As a result, most companies will err on the side of caution, and decide to reduce or
eliminate budgeted investments in new plant or equipment. When sales are soft or falling, every
dollar of revenue becomes more important, so many companies will increasingly compete on price to
boost revenue. Although this will narrow profit margins in the short run, it will help protect market
share for the long haul. Companies will also move to lower current costs, and millions of workers
around the world will lose their job.
Of course, the decision to play it safe makes sense. But, as millions of company executives, of firms
large and small, decide almost simultaneously to hit the brakes, the world economy will slow down
even more. As global worker income weakens, global demand for goods and services will decline,
which will lead to more job losses. This negative feed back loop will circle back and cause more
losses for banks throughout the world. Social unrest will increase in many countries, as unemployed
workers vent their anger, and demand their political leaders do something. In a few countries,
existing governments will collapse, and be replaced by new governments that won’t have much
success in turning things around either. We are on the doorstep of a darker age that will be pock
marked by more turmoil, violence, and brutality throughout the world.
I take no pleasure in writing these words. My goal is to analyze what is happening in the economy
and financial markets objectively, without a built in bias. Although I thought housing was clearly in a
bubble in 2006, I remained positive on the economy and bullish the stock market through the first
half of 2007. I didn’t turn negative until October and November 2007. I thought the Federal Reserve
would have more difficulty in containing this credit crisis, and became more negative as 2008
unfolded, when that assessment was proven correct. As 2008 was the year of the financial crisis,
2009 will be the year of the economic crisis. Unfortunately, as the economic crisis intensifies, it will
make the financial crisis more severe.
Worldwide production capacity for cars and trucks is 90 million units but demand is closer to 65
million units according to CSM Worldwide. With this much excess capacity, only the low cost
producers can survive. It was noteworthy that Toyota expects to lose money for the first time in 70
years. The government loans to GM ($13.4 billion) and Chrysler ($4.0 billion) will keep both firms
afloat for awhile, but will do nothing to address the downsizing both firms need to accomplish if they
are to survive.
Since August, weekly steel production has collapsed 50%, as construction and auto production,
which represent 57% of steel demand, fell sharply. Demand for appliances, machinery and electrical
equipment, which represent another 13%, have also weakened. American steel production hasn’t
been this weak since the early 1980’s.
The trucking and railroad industries represent the arterial system of the economy. More than 70% of
everything we buy is shipped by truck. According to the American Trucking Association, industry
volume fell 6.3% from July through October, and remained weak in November and December.
According to Longbow Research, railroad car – load volume is off 10%, from year ago levels. The
decline in shipping volume is having a big impact on demand for trucks and railcars. According to
FTR Associates, U.S. trucking companies are projected to buy just 100,000 trucks in 2009, down
22% from 2008, and 64% from 2007. The demand for new railcars in 2009 is expected to fall below
40,000, down from 58,000 in 2008.
In December, Industrial Production fell -2.0%, and tanked at an annual rate of 11.5% in the fourth
quarter. The 7.8% decline in Industrial Production since December 2007 is the worst since 1980.
With demand for freight hauling trucks, railroad cars, and passenger cars and light trucks contracting
by more than 30%, Industrial Production will only get weaker in coming months. The companies in
these sectors will be forced to postpone or curtail their capital investment plans in 2009, and trim
excess capacity. They will also be forced to cut more jobs.
In December, Retail Sales declined 2.7%, after falling 2.1% in November. The 2008 holiday
shopping season was the worst since at least 1969. After a dismal holiday season, and a bleak near
term outlook, many retailers will be forced to shutter under performing stores, and too many will
simply go bankrupt. According to AlixPartners, a turnaround consulting firm, of the 182 large
retailers it tracks, 25.8% are at significant risk of filing for bankruptcy, or are facing financial distress
in 2009 or 2010. The large increase from 7.2% in 2007 of firms at risk is due to high fixed costs,
which make them more vulnerable when sales weaken. With traditional retail lenders GE Capital,
CIT Group, and Wachovia Corp cutting back on their lending, retailers with debt coming due that
needs to be rolled over are particularly at risk. Changes in bankruptcy laws enacted in 2005 limit the
time a retailer can remain in bankruptcy to 210 days, and make it very difficult to turn a business
around, especially when the economy is weak. The International Council of Shopping Centers
reported that 148,000 stores closed in 2008, and estimates another 73,000 will close in the first half
of 2009. In other words, things aren’t going to get better. And with every store closing, more jobs are
The $3.4 trillion commercial real estate mortgage market is far smaller than the $12 trillion
residential mortgage market. But additional losses for banks from this sector won’t help. According
to Foresight Analytics, delinquent commercial mortgages on banks’ books soared to 2.2% on
September 30, 2008, from 1.5% at the end of 2007. And that was before the economy fell off a cliff
in the fourth quarter. Banks and savings and loans could be especially at risk since they own almost
50% of all commercial mortgages outstanding. As I noted last spring, almost 1,400 of these
institutions had more than 300% of their Tier 1 capital in commercial mortgages. This suggests the
balance sheet squeeze on the capital of the largest banks will increasingly impact small and medium
size banks and savings and loans.
Consumer credit totals about $2.6 trillion, of which $800+ billion is in credit card debt. Over the last
year, the charge-off rate has soared from 4.6% to 6.6%. With the surge in job losses in the fourth
quarter, the charge-off rate will certainly exceed the previous peak of 7.5%, and probably make a run
at 10% by early 2010. Of the $800 billion in credit card debt, about $335 billion has been securitized.
With the asset backed securities market still dysfunctional, the cost of borrowing for credit card
issuers hasn’t gotten cheaper. More importantly, if charge-offs exceed 10%; the excess cash flow
from a pool of securitized credit card debt could turn negative. If it does, the issuer is required to pay
the full amount of the securitized debt to the bond holder. This isn’t going to be a problem in the
short run, but later this year it could be, and result in a consolidation within the credit card industry.
Of course, in the short run, rising charge-offs will simply mean more losses for the large banks.
In December, 524,000 workers lost their jobs, which brought total job losses for 2008 up to 2.6
million. Of that total, 1.8 million were lost in just the last four months. The average work week fell to
33.3 hours, the lowest since records began in 1964, and the unemployment rate jumped to a 16 year
high of 7.2%. In the next six months, another 2 million jobs or more will be eliminated. This will
cause the default rate on every type of consumer credit to climb, creating more losses for banks, large
and small alike.
In 1993, the personal savings rate was just under 8%, and consumer spending was less than 67% of
GDP. In the last 15 years, consumer spending has climbed to 71% of GDP, and the savings rate has
dropped below 1%. As I discussed last April, one of the secular trends I expected to develop was an
increase in the savings rate. Many baby boomers had planned on their home equity to fortify their
retirement plans, and the significant decline in home prices was an unexpected shock. The decline in
home values and the stock market has wiped out around $12 trillion in assets, or more than 20% of
consumer wealth. Household debt as a percent of GDP has climbed from 44% in 1982 to 98% in
2007, limiting future economic growth from debt accumulation. With home prices not likely to
rebound anytime in the next few years, many Americans are being smacked with a very unpleasant
thought – “Oh, my gosh, we’re going to have to start saving!” What’s good for the soul is not
necessarily good for the economy. For the first time since the Federal Reserve began tracking it in
1952, household debt fell in the third quarter of 2008. And, not surprisingly, the savings rate has
started to climb. If the savings rate increases from 2% to near 8% over the next 3 years, annual GDP
will be 1.25% weaker, than when we were a country of happy spendthrifts.
Although it may be hard to appreciate just yet, a cultural change is taking hold. In coming months
and years, thrift will become the new cool. After decades of living by the code that more is more, a
growing number of Americans will have a simple awakening – less is more. With so many people
adversely affected by tough times, it will become fashionable to use less of everything. There will be
no shame to admit using coupons, making fewer trips to the shopping mall, or only going to
Starbuck’s three times a week. Over indulgence will be frowned upon, as being passé and wasteful.
Maybe the greatest insight will be that most people will realize they’re OK. They really didn’t need
half the ‘stuff’ they thought was important. The irony is that less has always been more. We were
just blinded by the rational notion that more was more. Ha!
States over the last 30 years have increased their annual spending by 6%, which has added .3% to
.6% to annual GDP. State legislators have proven very adept at increasing spending, but I doubt they
will perform their duties with as much gusto in an era of frugality. Almost a year ago, I warned that
many states would be forced to raise taxes and fees and cut services in their 2009 budgets, which
began last July 1, since by law states must balance their budgets. The National Conference of State
Legislatures estimates that states will run budget short falls of more than $100 billion over the next
two years. The states will get help from Washington, and many states will find it easy to enact tax
increases on tobacco, alcohol, and soft drinks. A number of states will be forced to make tougher
choices, like raising gasoline taxes, which now average $.30 a gallon, on top of the $.184 tax by the
federal government. With Americans driving fewer miles and using less gas, highway transportation
funds are running short. For those states under the most pressure (California, New York, Florida and
a number of Midwestern states), the prospect of actual job cuts is more than possible. You know the
economy is in really bad shape, when government jobs are eliminated. And more than a few states
will be forced to reduce or eliminate long-time services, which will not go over well, and lead to
marches on state capitols by legions of disgruntled citizens.
As the economy has slowed over the last 18 months, the one area of strength has been the growth in
exports, which has added about 1% to GDP. Alas, exports have declined four months in a row. But
the slowdown in exports tells us even more about the global economy. Japan, the world’s second
largest economy, experienced a 27% plunge in its November exports and is now in a deep recession.
The fourth largest economy, Germany, saw its GDP sink for the third straight quarter, and contracted
as much as 2% in the fourth quarter. It is likely in its worst recession in decades, as is Great Britain
the fifth largest economy. China, which became the third largest economy in 2007, saw its exports
decline for the second consecutive month in November. This is significant since China gets 23% of
its GDP from exports. Although China has seen a large increase in their ‘middle class’ in the last
decade, domestic consumption will not make up for the export short fall. China is going to have a
problem with excess capacity too.
After 6 years of solid double digit growth, many Chinese business managers added to production
capacity, in anticipation of future export growth and rising domestic demand. Much of this capacity
increase was encouraged by provincial banks, at the behest of the Chinese government, which
wanted to create jobs for Chinese workers migrating to cities. If I’m correct about the excess capacity
problem in China, there will be banking problems and social unrest, as job growth stagnates. Since
Chinese growth is seen as somewhat bullet proof by global investors, any growth problems in China
will rattle the expectations for global growth improving in 2009.
The Federal Reserve has slashed the Federal funds rate from 5.25% to near 0%, and has expanded its
balance sheet from $900 billion to $2.2 trillion. The Treasury Department has dispersed $350 billion,
with another $350 billion to follow shortly. Our government has guaranteed $5.5 trillion in
mortgages issued by Fannie Mae and Freddie Mac, as well as guaranteeing more than $7 trillion in
deposits in banks and savings and loans, and another $3 trillion in money market deposits. The goal
of these efforts was to address a decline in home prices and support the economy. Despite all of these
unprecedented steps, home prices have continued to slide. The Standard & Poors/Case-Shiller 20
City Home Price Index fell by a record 18% in October, and has undoubtedly fallen further since. In
2008, 2.3 million home owners entered foreclosure proceedings, an increase of 81% over 2007. With 1.8 million jobs lost in the last four months of 2008, and another 2 million likely in the first half of 2009, an increasing number of homeowners will be falling behind on their mortgage payments. An eleven months’ supply of existing homes for sale and a high level of foreclosures will pressure home prices well into 2009, probably knocking off another 10% in value. As long as home prices keep
falling, more homeowners will be carrying mortgages that exceed the value of their home, and total
losses for banks can only be open end estimate.
So far banks have written off $1 trillion, but credible estimates suggest total losses will approach
$1.6 trillion, and probably more. This means banks have another $400 to $600 billion in losses to
book, if not more. The banking system is broken, figuratively and literally, and that is why many
banks can’t afford to lend the TARP money they have received. After the Treasury disbursed $250
billion to banks in November, I said I thought they would probably have to provide another $250
billion, given the sorry state of many bank balance sheets and future losses.
Although total commercial and industrials loans by banks have increased in the last six months, a
deeper analysis of why loan volume rose is interesting. According to Harvard Business School
professor David Scharfstein, banks have commitments for more than $3.3 trillion in revolving credit
lines. When the commercial paper market shut down in September and October, many companies
were forced to draw on credit lines that had been negotiated in 2006, when lending standards were
far looser than today. Other companies voluntarily decided it was smart for them to add to their cash
positions, while the money was available at such attractive terms (50 to 150 basis points above
Libor). Since banks must manage their balance sheets and capital needs based on previous
commitments, they need new capital to support future lending above the $3.3 trillion they’ve already
committed to lend. Professor Scharfstein found that from August to October new loans to large
corporations actually declined by 36% from the prior three months. Loan losses are shrinking the
capital base and balance sheets of many banks, and forcing them to sell assets at a less than
advantageous time. More importantly, a shrinking capital base will continue to have an adverse
effect on future lending, until the government has added all the capital needed to cover a rising,
and unknown amount of total losses. According to Reuters Loan Pricing Corp, for all of 2008 loan
issuance plunged 55% to $764 billion from $1.69 trillion in 2008. Investment grade loans fell 52% to
$319 billion, while leveraged loan issuance dropped 57% to $297 billion.
As I discussed last December, I thought the Federal Reserve would have more trouble containing the
contraction in credit in this cycle because today more credit is created outside the banking system
than in the past. Thirty years ago, banks provided upwards of 75% of all credit. As securitization
markets developed for mortgages, auto loans, and credit cards, banks’ proportion of total credit
creation has dropped to 35%. This is why the Federal Reserve needed to resuscitate non-bank credit
creation by buying mortgage backed bonds and other asset backed securities, if credit creation is to
be rejuvenated. Their efforts have already helped bring mortgage rates down, but it will take time to
restore the trust and volume of transactions necessary to support a healthy economy. Securitization of bank lending is down by more than 75%, the volume of commercial paper being traded each week is
down by more than 25% (even after $300 billion in Fed purchases), and the volume of asset backed
commercial paper is off 40%.
Of course, there are positives. As Larry ‘Right on everything except the financial markets and
economy’ Kudlow notes, the dramatic decline in energy prices since their peak last July, and the dip
below 5.0% on 30-year fixed mortgages are supportive. Or, as Larry loves to call them, ‘mustard
seeds’. This is an apt metaphor for a hot dog like Larry, who repeats his catch phrases with the
repetitiveness of a Tommy Gun and the subtlety of a 2 by 4. But Larry overlooks that consumers
spent less than 20% of the $100 billion in tax rebates they received in the second quarter of 2008, and
are likely to save most of their energy savings, or use it to pay off debts. Although this ‘mustard
seed’ won’t give the economy much of a boost in the short run, it will help consumers rebuild their
savings, which is a plus. The drop in 30-year fixed mortgage loans to their lowest level since the
1950’s will help, but not as much as expected. According to Fannie Mae, almost 70% of their
borrowers won’t be able to refinance, because they don’t have sufficient home equity, hold jumbo
mortgages above $625,000 or have poor credit. BB&T Corp based in North Carolina is only approving 58% of its applications, while Seacoast National Bank in Florida approves only 25% of its
The biggest ‘mustard seed’ is the stimulus package that President Obama will unveil in coming
weeks. It seems to grow by $25 billion or more as each week passes, and will include tax cuts and
big spending on infrastructure and alternative energy. A little something for almost everyone, so
what’s not to like. It will help spur some demand, which is desperately needed, although it won’t
really hit stride until very late this year or early 2010. As we wait for the cavalry to arrive later this
year, economies that comprise more than 75% of world GDP will be slipping deeper into recession.
By the time it arrives in force, more than 2.5 million workers will be displaced from their job in the
U.S., as will 8 or 9 times that many around the world. The fate of GM and Chrysler will have been
decided, home prices will be lower, and losses from all forms of credit will cost banks $500 billion or
more in precious capital. I think President Obama’s stimulus plan could play a significant role in
keeping the worst recession since the 1930’s from becoming a depression.
This view is not shared by a majority of analysts, who expect the stimulus plan to arrest a deep
economic contraction and a serious wave of deflation, and launch a recovery. They may be right. But
many of these optimists have consistently underestimated the power and scope of the credit crisis and
its impact on the economy. In the summer of 2007, the housing crisis was dismissed as just a subprime
mortgage problem. By late 2007, investors were advised to invest overseas to minimize the
effect of a U.S. slowdown on their portfolios. When the odds of a U.S. recession increased in the first
quarter of 2008, the concept of decoupling was heavily promoted, on the belief the rest of the world
was strong enough to ‘decouple’ from a sinking U.S. By August 2008, it was obvious the rest of the
world was succumbing to a serious slowdown. No problem. Since the U.S. was the first into this
mess, it would be the first out, and small cap stocks were the best way to cash in. Small cap stocks
promptly lost more than 40% of their value in less than 2 months.
Undaunted, these analysts have pulled out their history books and noted that the two longest
recessions since World War II each lasted 16 months. This recession began in December 2007, so it
‘should’ be over around April 2009. Granting that this recession may be a bit worse, they accept it
could last a few extra months. From an investment standpoint, it shouldn’t matter, as the stock
market usually bottoms six months before the economy troughs. (But if the economy bottoms later,
you could be prematurely toasted.)
I don’t have a problem with using 16 months as a yardstick to guess when this recession will end. I
do question using December 2007 as the starting point, since the garden variety recession that began
in December 2007 clearly morphed into something far, far worse in September 2008. If September
2008 is used, the worst recession since the 1930’s won’t end until January 2010. And that’s if it only
lasts 16 months.
MACRO INVESTMENT STRATEGY
If you think the economy bottoms between April and July, it probably makes sense to buy stocks
now, since the downside would be somewhat limited. You’ll also be inclined to buy gold and gold
stocks because all the Fed liquidity would lead to more inflation sooner, if the economy improves
quickly. You’d sell Treasury bonds, but buy corporate bonds, as an improving economy will curb
default rates and narrow the spread between corporate bonds and Treasuries.
On the other hand, if the economy remains in recession until the end of 2009 or early 2010, all these
moves could take a fair amount of heat in the short run, even if they eventually work out.
The stock market was very oversold as it reached its low on November 21, and investor sentiment
was lopsidedly bearish. Between the end of November and January 9, the S&P fell from 896 to 890.
But, during this 5 week window, the plurality of bulls and bears in the Investor’s Intelligence survey
swung from there being -15.1% more bears, to +7.7% more bulls, while the AAII survey showed a
swing from -13.6% more bears to +13.6% more bulls! This is a dramatic shift in such a short period
that would only be understandable, if the S&P had rallied 10% or more. It is unhealthy for bullish
sentiment to have increased so much absent a big rally, which underscores how advisors and
investors have really bought into the notion that the economy will turn by mid 2009. And,
technically, by early January, the market was overbought.
Sometime in the first half of 2009, the S&P will challenge and likely break below the November low
at 740. I don’t know if this decline will end at 739 or 699. The DJIA will fall below 7,450, and
ideally below the 2002 low of 7,197 That’s the bad news. The good news is that once that decline is
over, the market will enjoy the largest rally since the bear market began in October 2007. It will be
ignited by economic statistics showing that the rate of decline in the economy is getting less bad. The
optimists will jump to the conclusion that less bad equals recovery.
I advised investors to sell into strength in July 2007 when the S&P was 1535, in October 2007 when
the S&P was above 1550, in May 2007 as the S&P peaked above 1420, and over 1310 in August. In
November, I advised buying as the DJIA fell below the October low of 7,882, and selling at 8,600 in
December. On January 5, 2009 I thought the market was within 2% of a high. The S&P popped less
than 2% on January 6, and then fell more than 13% over the next 7 trading days. The next several
months are going to be challenging, as the market deals with a wall of ugly news and the hope of
better times to come.
I would not buy Treasury Bonds. But it is way too early to go short, if the economy remains weak
until much later in 2009. Bonds are likely to remain in a trading range, with the 10-year Treasury
holding between 2.2% and 3.07%. In coming months, Treasury bonds will rally when the economy
looks terrible, and sell off on any piece of news that is not as bad as expected. A good environment for short term traders. If the stock market does indeed drop to new lows, it will present a good buying
opportunity for a trade in corporate bonds and high yield bonds.
Inflation has been defined at times, as too much money chasing too few goods. What we are
experiencing could be best described as too little money chasing too many goods. The Fed has added
reserves to the banking system. But banks are not lending, and are actually restricting credit
availability. Although the money supply measures have been growing, the velocity of money has
slowed markedly. Unemployment is soaring, and worldwide factory utilization rates are dropping
like a stone, which means there is plenty of excess capacity in the global economy. All of these
factors will change some day, but not anytime soon. In the meantime, there will continue to be
downside pressure on raw material prices and labor costs. In coming months, consumer prices will
register declines, driving home the larger risk of deflation. If the Gold market is anticipating a surge
in inflation, those buying now must be using binoculars, or even a telescope. As long as February
Gold does not close above $900, a decline below $700 is still expected in the first half of 2009.
After mid July 2008, the Dollar rallied as the financial crisis intensified, and then sold off sharply as
the stock market rallied off the November lows. I think we are past the acute phase of the credit
crisis, which is why credit spreads have narrowed. But we are heading into the teeth of the economic
crisis, which will likely give the Dollar another boost. I think the Dollar will at least run up to 90 –
92, in coming months. A decline below 81.20 would challenge this view.
E. James Welsh