David Rosenberg is a 20 year veteran of the Street, David most recently was Merrill Lynch’s chief North American Economist, where he correctly warned about the Housing and Credit Collapse and Recession in advance. He is the Chief Economist of Canada’s Gluskin Sheff
What made things so interesting is that in 2007, when I was at Merrill and calling for a recession, it was such an outlier view even though it seemed so obvious to me at the time. To think that it only became a widespread consensus view in the fall of 2008 when the downturn was already in full force for a good eight months. Back then, the bears still felt they had to be vindicated, and of course, the only barometer that seems to matter to anyone was the stock market, which gave absolutely no ‘heads up’ at all for what was to come down the pike. But now, it is universally viewed that the recession is over, that a recovery has begun, and a growing number of commentators are calling for 4%+ real GDP growth for 2010. We have never been a fan of group-think, but that is what we have on our hands today.
The question really is how robust is the economy and what is the root of optimism. It comes down to the massive doses of medication that have been applied by Uncle Sam. Unless we want to sustain state capitalism, which is what we had by the way, throughout the 1930s and 1940s, then this unprecedented public sector incursion into the capital market and the economy is going to have to end at some point.
But when you have a system that continuously extends unemployment insurance, provides subsidies for cars and homes (and the latter is still being considered as an extension at a cost of over $1 billion a month for the taxpaying public) not to mention the credit-boosting initiatives by the Fed and the FHA. The Obama team is now considering a capital infusion into small businesses as a means to bolster employment in this critical part of the economy. Friday’s WSJ also suggests that the Democrats are mulling over tax credits for “additional big ticket items.” Yes, that is true. Despite all the fraud involved in the homebuyer tax credit plan, its extension and indeed expansion is not being discussed in Congress. (100,000 improper claims for the tax credit? Who cares? It’s for a good cause.)
All of this (you have to see the Tim Geithner interview in BusinessWeek) is not being dubbed another fiscal plan — it is only an “extension” of the first. At the same time, we have a system where all the big banks have been safeguarded by the government and the liabilities of the entire system guaranteed by the taxpayer. Deficits continue to be racked up — $1.4 trillion in the past year and over $1 trillion as far as the eye can see and we are still being told that this all the fault of the prior Administration. The question that has to be asked is, while the coupon payments will be made, do the entities who are buying U.S. Treasuries today really ever expect to get their capital back? Without either deep spending cuts or tax increases (a dirty three-letter word in the U.S.A. — remember Bush Sr.’s “read my lips” back in the early 90s that cost him the election?) the only way out of this fiscal mess caused perhaps by the prior Administration and now accentuated by the current Administration will be by monetizing the debt.
If the President is not up to pushing top marginal tax rates to over 80%, as FDR did back in the 1930s (back then, people understood the meaning of the word “sacrifice”) then will Mr. Bernanke be up to the task to monetize the debt that the federal government has basically assumed from the household sector? And will he be supported by the regional Fed bank presidents because this would involve the mother of all reflation efforts (see Mr. Bullard’s comments from Friday not to mention the dissention so evident in the latest set of FOMC minutes)? Perhaps this is why gold has managed to hit new highs in recent weeks — somebody out there is buying gold and this has to be the greatest thorn in the side of the equity bulls because if in fact we are in this new era of financial and economic stability, bullion would not be in a bull market.
In case you missed this, Steven Hess, Moody’s lead analyst for the U.S.A., said this late last week on Reuters TV (and reprinted in the Investor’s Business Daily):
“The Aaa rating of the U.S. is not guaranteed. So if they don’t get the deficit down in the next 3-4 years to a sustainable level, then the rating will be in jeopardy.”
Also have a look-see at Tomorrow’s Burden: America’s Debt Crisis Will be Chronic, Not Acute on page 80 of the Economist. Did you know that the share of U.S. federal government debt maturing in a year has shot up to 40% from 30% in less than a year (highest in nearly 30 years)? If this was any other country, it would already be on credit-watch because not only is there massive “rollover risk”, but when you consider that total government debt, including the states, is already 100% relative to GDP, which is the critical level that in the past touched off downgrades from AAA status in Canada and Japan in the 1990s. The prospect of the world’s reserve currency not possessing gilt-edged AAA status adds a cloud of uncertainty to the financial market outlook.
This is one reason why gold is a buy since it is the classic hedge against uncertainty and instability. While demand for gold is never certain (what’s the dowry outlook in India this year?), the supply of gold is reasonably certain (outside of the periodic jewelry meltdown parties). We know how much is above ground (almost all of it), and we know how much there is below ground and the marginal cost of pulling the yellow metal out of the ground. We don’t know how many greenbacks the U.S. is going to be printing in the future, but something tells us that for a society that is willing to allow zombie banks to survive because it could not stomach another Lehman-type collapse, is a society that will try to find the easiest way out for its population to extricate itself from the credit excesses it took on. Look at the efforts, in terms of court-enforced mortgage cramdowns, government-forced loan modifications, foreclosure moratoria by edict, and this coming week, the White House is going to be demanding that mortgage servicers provide borrowers with “more specific information as to why their modification request was denied” as per A2 of the weekend WSJ – wave bye-bye to tort & contract law.
In the final analysis, we all should know how this is going to play out. It is going to be somebody else that foots the bill for all this government incursion, and that is very likely the creditors who hold U.S. government paper. Not that the U.S. would ever default; that will never happen. However, there is very likely going to be a stage where this mountain of public sector debt gets monetized, and while gold is inherently difficult to value, what is going to drive the price higher, in the future, to new record highs will be the supply of bullion relative to the supply of dollars. (The Fed has already created nearly $2 trillion of excess dollars in the last two years — consider that to be the thin edge of the wedge with fiscal deficits of $1 trillion-plus through 2011, which will need to be financed somehow.) Emerging markets that got into trouble in the past could not reflate their way out of their U.S. dollar liabilities, but America can. Let’s face it, the degree of retrenchment that would be needed to bring the deficit-to-GDP ratio down to the 3-4% level that would allow the debt/GDP ratio to stabilize, would simply be too much for the U.S. electorate to put up with.
The one thing we can say with earnest is that Americans will never be forced to endure what Asians did during their depression of the late 1990s because no politician would ever let that happen without risking another term in office. These fiscal consequences are going to be borne by somebody else — the foreign holders of U.S. dollars. In the land of the blind, the one-eyed man is king, and Canada has never looked this good.
The OECD estimates that the amount of stimulus injected into the U.S. economy is equivalent now to 5.6% of GDP. So if we were not seeing at least a statistical recovery in the economy, well that would mean real trouble. Only the basket case of all basket cases would not be at least showing an arithmetic bounce-back at this juncture, considering all the steroids that have been administered by the Administration. The question of sustainability has not gone away. The current issue of there being an extremely wide distribution curve of possible outcomes has not gone away. The fact that banking sector profits — and the trickle down to other sectors — has been largely due to the gifts from Uncle Sam in the form if mark-to-model accounting, debt guarantees and a super-steep yield curve — are not lost on us. Most of the folks who bought the banks have no clue what their assets are really worth or what the future earnings power really is — but they were powerful short-covering trades for several months earlier this year and served as the launching pad for the powerful bear market rally.
The only thing that caught us off guard was the willingness for investors to bid up the P/E ratio by a full nine points from the March low to their highest level in years. It took a great deal of government intervention to achieve the lows in the economy and the market, but our thought process on such a low-quality, stimulus-dependant rally would have entailed a lower multiple — the proxy for investor confidence — than what we have on our hands today.
In other words, this is not the onset of a sustainable secular bull market as we had coming off the fundamental lows of prior bear phases, such as August 1982, when:
• Dividend yields were 6%, not sub-2%.
• Price-to-earnings multiples were 8x, not 26x.
• The market traded at book value, not over two times book.
• Inflation and bond yields were in double digits and headed down in the future, not near-zero and only headed higher.
• The stock market competed with 18% cash rates, not zero, and as such had a much higher hurdle to clear.
• Sentiment was universally bearish; hardly the case today.
• Global trade flows were in the process of accelerating as barriers were taken down; today, we are seeing trade flows recede as frictions, disputes and tariffs become the order of the day.
• A Reagan-led movement was afoot to reduce the role of government with attendant productivity gains in the future; as opposed to the infiltration by the public sector into the capital markets, union sector, economy and of course, the realm of CEO compensation
We acknowledge that the equity market surprised us to the high side from March to October by significant proportions. We had expressed our cyclical view in the credit markets, where there was and still is less risk involved but more income potential, and our clients have been well served by this prudent approach. We guarantee that the same folks playing the stock market today with expectations of sustained huge returns ahead, and the market pundits, bloggers and bubble-vision commentators who continue to advocate overweight positions in equities, are the very same ones that did not read the tea leaves accurately in 2007 and have once again placed their clients in great danger.