The Dismal Outlook for 2012

The Dismal Outlook for 2012
Peter T. Treadway
January 1, 2012


“Dismal” is the only word I can think of to describe the economic and political outlook for the coming year. Deep recession seems almost unavoidable for Europe. Governments in all the so-called advanced countries face mounting debt and long term unfunded entitlement liabilities, huge banking problems and negative long term demographic trends. Governments’ response will be to pillory the so-called “rich” as much as possible, levy higher taxes in a variety of ways, enact various measures of financial repression, pile on more and more regulations, print more money and ultimately continue the default process that began with Iceland and Greece. The only “good” that comes out of this will be an increased reluctance to engage in ill-advised wars (I’ll let the reader decide which recent wars were ill-advised) simply because governments can’t afford them.

The Euro – I’ve been a big fan of the euro. The world needs the euro as a second reserve currency after the dollar. The renminbi just isn’t yet ready for prime time. And the euro makes so much sense for an ever more economically and financially integrated Europe. But the Europeans have managed to do everything wrong in response to the crisis. The list goes on and on. My recommendation was to let each nation be responsible for its own fiscal integrity. National defaults should be accepted as defaults by states and provinces were accepted for the US and Canada. That’s not what the Europeans have done. German Chancellor Merkel’s attempt to force fiscal responsibility on member states is a political nonstarter. The European Central Bank (ECB), regardless of what it says, is printing money to tidy over the Italian and Spanish huge 2012 borrowing needs. Talk German, act Italian, is the ECB mantra. The plan to do three year repos with the banks so that they can buy their home country’s bonds is a cynical repudiation of bank risk management principles, a debauching of the euro itself and to some extent a protectionist scheme that will encourage a sort of “beggar thy neighbor” approach to banking where banks only loan to their own governments. The banks need capital, not high risk lending schemes. Credit is going to be scarce in Europe in 2012.

The tax-oriented austerity schemes being adopted in Italy, Spain, Greece and elsewhere ensure that Europe will be in deep recession in 2012 and that Europe’s growth prospects longer term will be dim. There is talk of privatizations and pushing up state employee retirement ages. We’ll see. What is more likely is that the austerity packages just push Europe further down the road of more socialism and more state dominance of the economy. That is not a bright investment scenario. A further decline of the euro against the dollar would not be a surprise.

Gold – I’ve been positive on gold and long term still am. Gold was up 10 % in 2011 and outperformed all major assets except US Treasuries. But there can be no gainsaying that since reaching a high in August gold has been tanking. Near term this downward drift may continue. My view has been that gold is an alternative to owning continuously depreciating fiat currencies. The recent quantitative easing programs suggest further future fiat currency depreciations. But of late the market has viewed US dollar assets– and not gold– as the preferred alternative to other currencies. It doesn’t make sense to me but the market makes its own decisions. Moreover, with the massive liquidity squeeze centered in Europe, people no doubt are taking profits and raising cash by selling the one liquid asset they have profits in – gold. Emerging market central banks have been buyers of gold but the recent decline of the Indian rupee has reportedly reduced Indian retail demand.

US Treasury Securities – Just behind gold, longer term US Treasury securities rose 9.6% and were star performers in 2011. US government securities were perceived as a place of refuge. Amazing. Nobody could have been buying for yield or because of the outstanding US fiscal situation.

Let’s start with the yield. According to Irving Fisher and just about every economist who followed him, the long run the interest rate on a bond should equal the expected real rate plus the expected rate of inflation. The official rate of inflation, the CPI-U was up 3.4% year over year as of November. Ten year Treasuries yields averaged below that which means their real yield was significantly negative.

Not only that, there are a number of people – I am one – who don’t trust the government numbers. Governments which publish the inflation numbers have every incentive to understate those numbers. In Argentina it’s now against the law to publish an inflation estimate which differs from the flagrantly understated government number. In the US the calculation of the CPI was changed in 1980 and again in 1990. An advisory service called ShadowStatistics, using the earlier methodologies, comes up with much higher estimates for US inflation in 2011. Calculating the CPI isn’t as simple as it sounds and there are a number of choices that can be made. The government has every incentive to make choices that make the inflation number lower.

The point is that, unlike Japan where low nominal government bond yields have been positive in real terms because Japan has experienced mild but actual deflation, US government bonds have offered negative real yields. The US is not in deflation the housing bust notwithstanding. US government securities are a bad buy on a yield basis. Irving Fisher would never own one.

The US government’s fiscal situation on the face of it doesn’t seem any better than half the countries in Europe. (And neither does that of the British, as the French central bank has so ungraciously pointed out. But so far the British bonds get the Royal treatment as well.) Most people are familiar with the dreary US numbers so I won’t belabor them here. The size of the US deficit, the staggering total of unfunded entitlement liabilities, the growing debt load, the debts of the states, the endless gimmickry used to understate the US budget deficit – pick your statistic. And of course the Congress and the President are unable to agree on anything.

Who knows? Perhaps national muscles count in determining investor comfort levels. The US has ten nuclear powered Nimitz class aircraft carrier behemoths that can operate for twenty years without refueling and bases just about everywhere in the world. A psychic compensation for the skimpy yield on US government issues? Maybe Irving Fisher should put that in his model.

There is a good chance the US will be viewed as the ultimate refuge right up until the November 2012 elections. Those elections might be the most important in US history. Treasury securities may continue to lead a charmed life until then. If the fiscal conservatives (whoever they are) don’t sweep, then après la election, le deluge.

US Stocks – US stocks, perhaps basking in the same refuge aura as US Treasuries, have been global relative outperformers. The Dow Jones Industrial Average, which consists of 30 generally stodgy blue chips, was up 5.5% in 2011. The broader S&P 500 was unchanged and NASDAQ was down “only” -1.8%. That doesn’t sound great especially considering the year’s volatility. Who needs a heart attack and no return? But the US was the world’s star performer. Hong Kong for example was down -19%. The trendy BRICs of Brazil, Russia, India and China were down -25%, -21%, -35% and -19% respectively (all in US$ as of 12/27, taken from The Economist). Near term in 2012, if US Treasuries are the place money is hiding and the US economy outperforms Europe, the big US stock names may continue to receive similar favorable treatment.

Still, I don’t buy the hypothesis that the US economy is making a significant recovery. The consumer remains overindebted, income growth in real terms is negligible, the states are cutting back and raising taxes and Europe is entering deep recession and Asia a slowdown. People are getting excited over the recent decline in employment claims but there could be some distortions produced by the holidays. And again – no income growth, no big recovery.

Financial Repression The term financial repression is an old one in monetary theory, having first been used by economists John Gurley and Edward Shaw in the 1960s. More recently, Carmen Reinhart and Kenneth Rogoff, in their now seminal work This Time It’s Different as well as in follow up papers, have warned that financial repression was a likely weapon governments would use to deal with their overwhelming debt burdens. Financial repression simply denotes government measures undertaken to divert funds to themselves that otherwise in a free market would have flowed elsewhere. In plain English, that means the things governments do to screw investors in order to sell their debt obligations.

Quantitative easing arguably is a form of financial repression whereby yields on government debt are pushed down to below market levels at the expense of savers. Attempts to nationalize pension plans and force them to invest in government bonds at below market rates are another example of financial repression and such nationalizations have already been carried out in Europe. Expect to see more of this. So far the government has not touched IRA and 401K Plans in the US but don’t be surprised if an attempt is made.

Investors of the world, unite! Your savings are at risk of confiscation.

China – Hard landing, soft landing which will it be? That’s the question the world is asking. The Chinese people are hardworking, relatively well educated, the majority relatively undivided by religious and ethnic issues and totally materialistic. Characteristics thus far largely responsible for the Chinese economic success story. Nevertheless, I believe there may be no escaping from the fact that the Chinese economic system is in need of a substantial overhaul. The Chinese economic system is characterized by a government owned and dominated financial system that misallocates resources towards real estate, capital goods and industrial commodity inputs on a massive scale. It is driven by a mercantilist policy that has undervalued the exchange rate and stifled foreign competition. It has brought significant damage to the environment. And it is characterized by crippling restraints on the flow of information, financial and otherwise. A modern economy cannot function without the free flow of information.

I tend to the view that a hard landing lays ahead, one hard enough at least to force some major reforms. That would be good. The Chinese stock market today looks cheap on a PE basis. There may be some rallies in response to government easing in the months ahead. But for China to be a good long term investment the reforms have to be made. Unlike Europe the long term future of China looks bright provided reforms are made. When the time comes to buy, stay away from state owned firms and buy real private Chinese firms that trade in New York, Hong Kong and Singapore.

India – Three years ago the prospects for India looked bright. The ruling Congress Party had just been reelected with a larger margin and the Prime Minister was an Oxford PhD in economics who was viewed as the architect of India’s market oriented reforms of the 1990s. Indian companies and their managements are among the best in the world and, unlike China, information flows freely and in a language (English) most of the world can understand. India looked like it was fulfilling its potential at last and that it would offer great opportunities for investors. But since the election in 2009 it’s been all disappointment and the Indian stock market’s poor performance has reflected this. One reform proposal after the other has gone down in flames including proposals to allow larger foreign participation in the retail and education sectors. The one “reform” that was actually passed was an education bill that if enforced will effectively close down a substantial number of successful private schools. The Indian budgetary situation can be charitably described as precarious and inflation has remained stubbornly high. Worst of all, the Congress Party, presumably to please voters, is pushing through massive subsidy and employment programs which are bound to grow in size and present enormous budgetary challenges. The prior government, led by the Bharatiya Janata Party or BJP, had a slogan in 2004 called India Shining. The Congress Party’s slogan at the rate things are going might be India Bankrupt.

Indian equities are not interesting right now.

A Note on Race, Caste and Fiscal Prudence It is a core view that I have elaborated on in prior letters that democracies with universal suffrage have a long run tendency to spend their way into fiscal bankruptcy and degrade their currencies along the way. Investors have to recognize this phenomenon. The so called advanced West has reached that point of bankruptcy now. Politicians pass measures to please the majority that elected them, regardless of whether the country can afford it or not.

This phenomenon becomes more politically complicated if there is some difference – be it race, religion or caste – that differentiates the recipients of the government largess from those who produce the wealth, pay most of the taxes and dominate the professional and entrepreneurial classes. Normally in these situations the recipients, who are of a different race, religion or caste, believe they cannot compete with the professional/entrepreneurial groups and regard the government largess as an equalizer and redress for current and past wrongs.

Indian democracy provides an interesting case study regarding this point. The so-called Indian masses tend to be from “lower” castes (India has a complicated definitional scheme to formally identify these groups) than the professional and entrepreneurial groups running the businesses and generating the wealth. The democratic process in India has become a mechanism whereby the lower castes, who constitute significant “votebanks” and regard themselves as having been oppressed for centuries, appropriate wealth to themselves through the (unfortunately corrupt) political system. This may be why Indian politicians, who presumably really do know better, cannot say “no” to fiscally irresponsible welfare schemes.

The same phenomenon is observable in other countries, including South Africa and Brazil and even in the US where the word “race” can be substituted for caste and to some extent welfare and subsidy schemes carry racial overtones. In the US, when the real brawling over cutting back government spending starts after the 2012 elections, the subject of race will come up. Things could get ugly. Economists and Wall Street analysts don’t like to talk about these things for fear of being labeled politically incorrect. But they have investment significance.

China on the other hand does not have this problem, partly of course because it is not a democracy in which politicians have to appeal to voters but also because ninety percent of its people define themselves as Han and its minority groups are on the geographic and political periphery of the country. The lower income Han do not perceive themselves as different from the professional and entrepreneurial groups which are also Han. In this case China’s relative homogeneity – which is sometimes criticized as an impediment to creativity –can be viewed as an investment plus.


Dr. Peter T Treadway is principal of Historical Analytics LLC. Historical Analytics is a consulting/investment management firm dedicated to global portfolio management. Its investment approach is based on Dr. Treadway’s combined top-down and bottom-up Wall Street experience as economist, strategist and securities analyst.

Dr. Treadway also serves as Chief Economist, CTRISKS Rating, LTD, Hong Kong.
Historical Analytics • 118 East 60th Street 5D • New York, NY 10011

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