Introduction

Although I read and collect information and ideas every day, whenever the day comes each month when I actually have to start writing this report, the words of Gene Fowler (an extremely successful screenplay, sports, and humorous writer) come to mind: “Writing is easy. All you do is stare at a blank sheet of paper until drops of blood form on your forehead.”

On these occasions, I then usually turn to works of science, politics, history, or philosophy in the hope of calming down and finding some inspiration. Since so many investors look to investment advisers such as myself, whom they often call “gurus”, for guidance on the future of the markets, I think it is appropriate to remind my readers of these words of Lao Tzu (the sixth-century Chinese sage): “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

I have mentioned this because I was recently invited by my friend Manish Chokhani, of Enam Financial Consultants in Mumbai (the most successful investment bank in India), to give a presentation. The founder of the company, Vallabh Bhanshali, introduced me by saying that his staff consider me to be a hero for having correctly predicted the bull market in Indian equities in 2002, and for having called in 2006 for the 30% May/June sell-off. I felt deeply embarrassed by this, as I know only too well that I have made just as many, or even more, poor and erroneous market calls as correct ones in the course of my life, and not only about economics and asset markets but also about people… Moreover, I know people who are far more knowledgeable about the financial markets than I am – people such as Henry Kaufman and Peter L. Bernstein – who focus on presenting well-researched facts in their excellent papers, publications, and presentations, and refrain from making predictions.

In fact, addressing large audiences makes me feel uncomfortable – not because of the size of the audience, but because, as a contrarian, it is not desirable for my views to be popular and because assets that I consider will perform well in the future seldom attract large crowds. Two friends of mine, Jon Thorn and John Shrimpton, who manage, respectively, the India Capital Fund and the Vietnamese Dragon Fund, used to have tiny audiences when they presented at investors’ conferences. But as their markets more than doubled in size, so did their audiences.

In 1981, I was invited to speak about bonds at a gold conference that had attracted over 500 participants. Just one person came to my presentation. (September 1981 saw the end of the bond bear market, which had begun in 1942.) A small audience can sometimes be distressing for a speaker, but at such times they would be wise to remember Victor Borge, a Danish pianist with a sharp mind and humorous bent, who fled to the United States in 1940 and made a name for himself with his brilliant blend of musicianship and humour. One evening, in Flint, Michigan, Borge performed to a sparse audience. The sight of so many empty seats might have discouraged the average performer, but the witty Borge looked out over the audience and exclaimed: “Flint must be an extremely wealthy town. I see that each of you bought two or three seats.” (Lateral thinking at its best!)

As an investor looking for guidance from newsletters, blogs, financial publications, and conferences, I would also be mindful of Ralph Waldo Emerson’s words: “Do not go where the path may lead; go instead where there is no path and leave a trail.” Unfortunately, in today’s high-liquidity driven global investment environment, I find it hard to identify an asset class “where there is no path”. There are far too many smart – and not so smart – treasure hunters who have bid up every imaginable investment class right around the world. It is only in the most unusual places that I can find true value (often, however, in assets that are difficult to invest in), as opposed to relative values, which certainly do exist. The problem for investors is that, as the German theologian Dietrich Bonhoeffer wrote, “If you board the wrong train, it is no use running along the corridor in the other direction.” (Bonhoeffer opposed Nazism and was executed in prison for his involvement in a plot to overthrow Hitler.)

I mention this because it will become increasingly important for investors not only to decide which asset class train they want to board, but also, and even more importantly, whether they want to board any of the asset trains. If we look at the economic and financial history of capitalism, we can see that over periods of five to ten years there were always some assets that performed well. But there were times, such as in the early 1930s and the 1970s, when very few assets appreciated. Gold and gold shares performed well in the early 1930s. And in the 1970s, precious metals, and energy and energy-related shares, appreciated dramatically. But what were the chances that, in 1929, an investor would have had all his assets in gold, or, in the 1970s, in energy and precious metals-related investments? Moreover, in both cases, these investments had to be liquidated at some point because, as is always the case, “over-staying” eventually leads to huge losses. And this is where I see the biggest problem in the current investment environment. At the beginning of a bull market in an asset class, there are very few participants. But by the tail end of the boom the vast majority of market participants have become convinced that the boom will last forever or that a greater fool will soon emerge and take them out at a higher price. (This is likely to be the thinking among private equity fund managers.) So, in every boom, the majority of investors eventually get caught when the investment bubble bursts, as was the case in 2000 with high-tech stocks and in 2006 with US homes.

In last month’s report, entitled “When Too Many Investors Think Alike, Nobody is Thinking”, I pointed out that a peculiar feature of the bull market in asset prices since 2002 has been that all asset prices around the world have appreciated in concert as a result of highly expansionary monetary policies, which has led to excessive credit growth and a credit bubble of historic proportions. Therefore, if my theory of slower credit growth in future holds, it is conceivable that, for a while at least, all asset markets (with the exception of bonds and cash) could come under pressure, albeit with different intensities.

In fact, asset markets would come under pressure even if credit growth continued at the present rate and didn’t accelerate. In this instance, investors would be better off not boarding any investment train at all and, instead, staying at the station loaded up with cash. (However, they would still have to decide what kind of cash to hold.)

An Attempt to Pierce Through the Investment Mist

I have mentioned in the past that the first signs of credit tightening would be visible in the performance of US brokerage stocks. Recent pronounced weakness not only of brokerage shares, but also of other financial stocks and, in particular, sub-prime lenders, would seem to confirm that the “irreparable cracks in the financial system”, about which we wrote in the January issue of this report, are now spreading. These cracks are now causing some “illiquidity”, not only in the household sector but elsewhere in the system as well. First, it is important to understand that mortgage debt has begun to grow at a slower pace largely because home prices are no longer appreciating. The growth in the mortgage market was about equal to nominal GDP growth between 1980 and 2000. But, in the 2000 to 2006 period, a massive breakout from the trend occurred and, combined with a decline in the saving rate, drove consumption and GDP growth. But, as home prices began to decline in 2006, and as problems in the subprime lending market became evident, lending standards were tightened to their highest level in 15 years. Declining home prices and tighter lending standards brought about a slowdown not only in mortgage debt growth but also in overall debt growth. Mortgage debt, which grew at an annual rate of 10.2% in the second quarter of 2006, declined to an annual growth rate of 8.6% in the third quarter and to 6.4% in the fourth quarter. It is likely that mortgage debt growth slowed down further in the first quarter of 2007, and will decline even more in the second quarter given the problems in the sub-prime lending industry and the tight lending standards.

In the meantime, household debt growth in the United States has declined from a peak of 11.9% in the third quarter of 2005 to 6.6% annual rate in the fourth quarter of 2006. According to David Rosenberg, the fourth-quarter 2006 annual credit growth was the slowest since the third quarter of 1998 and the sixth consecutive quarterly deceleration, “which hasn’t happened since 1956″ (emphasis added). Now, ceteris paribus, this significant slowdown in mortgage and household debt accumulation would have already brought about a significant slowdown, or even a decline, in US consumption. However, because of the stock market rally in the fourth quarter of 2006, equity wealth increased by 4.2%, or an annual rate of 18%.

Moreover, as David Rosenberg notes, “just as households are beginning to curb their appetite for debt, the once-dormant corporate sector stepped up its borrowing sharply in Q4 (M&A related perhaps?). Net debt raised by the nonfinancial corporate sector steamed ahead at a 10.9% annual rate in Q4, almost double the Q3 pace (of 5.9% annualized) and the strongest pickup in seven years. You have to go all the way back to the cashburn era of 2000 Q2 to see the last time that the corporate sector outdid the household sector in terms of debt buildup.” And as David Rosenberg correctly suspects, corporate borrowings have been rising along with M&A activity. But corporate borrowings are far smaller than household debt; therefore, while corporate debt growth has increased by around US$100 billion since the second quarter of 2006, household borrowing has grown since then by around US$300 billion. (Note also how, in the late 1990s, debt growth took off.)

Now, this deterioration in household debt growth hasn’t yet led to a consumer spending decline; but, very clearly, retail sales are now growing more slowly. Continuous consumption growth was therefore driven less by household debt growth in the fourth quarter of last year and the first quarter of this year, than by the continuation of an increase in household wealth and the selling of US equities by the household sector. But herein lies the problem. If declining home prices are now joined by equity prices that are either declining or no longer rising, it will only be a matter of time before consumer confidence declines and the consumer either slows down their spending further or stops spending altogether.

Slower consumption growth, as a result of tighter lending standards and flat or declining equity prices, should have the following consequences. The US trade and current account deficit will no longer expand at an accelerating rate. This should lead to a relative tightening of global liquidity, which would likely be unfavourable for asset prices but could temporarily strengthen the US dollar and even more so the Yen.

The full extent of the sub-prime lending problems isn’t known. However, since at least 12% of the mortgage market – whose total size is over US$1.2 trillion – is comprised of sub-prime loans, the fall-out could be considerably worse than expected. This certainly seems to be indicated by the recent poor performance of banking stocks and, as indicated above, brokerage shares. My friend Gerard Minack of Morgan Stanley recently published a figure showing how financial sector earnings have exploded in recent years. Figure 12 depicts earnings growth for the financial and nonfinancial sectors indexed to a common base (1990 = 100).

As can be seen, the financial sector’s earnings rose 14-fold since 1990 to an annualised US$251 billion, whereas the rest of corporate earnings experienced only a fourfold increase, to US$636 billion. I have mentioned in earlier reports that if we were to include in the financial sector’s earnings financial profits from speculating in all kinds of derivatives and financial products by industrial and multinational companies, the profit contribution from financial earnings to S&P 500 total earnings would be more like 45%. Also, the recent contribution to profit growth would amount to around 70%. Therefore, I suppose that if asset markets failed to appreciate further, financial earnings would begin to decline and likely pressure S&P 500 earnings. (Aside from the financial sector, the energy and material sectors have in recent years also boosted S&P earnings. Never before have energy and financials contributed so much to the S&P profit pool.)

In the past, poor performance of financial stocks has always been an unfavourable indicator for the entire stock market. In an economy that has become addicted to credit growth, this should be even more so! The other point to remember is that if corporate profits no longer expand, the ammunition used by the corporate sector to take over other companies and to buy back their own shares is likely to diminish. Last year, a record US$548 billion worth of shares were retired by corporations buying back their own shares and by acquisition-minded private equity funds. Any reduction of this activity in 2007, when simultaneously the increasingly “illiquid” household sector is likely to diminish its equity purchases further, is going to have an unfavourable impact on the stock market. I may add that, sooner or later, private equity funds will place the acquired companies back on the stock market and so increase the supply of equities through high IPO activity.

If the assumption is correct that global liquidity is tightening – at least relatively – as a result of a stagnating US trade and current account deficit, the asset markets that benefited the most from surplus liquidity should come under some pressure. I am thinking here in particular of the extended emerging stock markets, which in this scenario could be vulnerable to corrections of between 20% and 40%. In turn, a decline in these peripheral markets should have an impact on Japan and, in particular, on the Yen.

Regards,
Marc Faber, PhD

April 16, 2007

“Relax, the Over-all Market Probably Won’t Tank” was originally featured on Whiskey and Gunpowder

For those unfamiliar with the term “carry trade,” I will use the definition found on Freebuck.com.

“Carry trade — The speculation strategy that borrows an asset at one interest rate, sells the asset, then invests those funds into a different asset that generates a higher interest rate yield. Profit is acquired by the difference between the cost of the borrowed asset and the yield on the purchased asset.”

Nightmare Scenario

I view the nightmare scenario something like the following:

1. End of quantitative easing (QE) in Japan
2. End of ZIRP in Japan (Rising interest rates)
3. Rising interest rates in Europe
4. Falling interest rates in the U.S.
5. Tightening credit in the U.S.
6. A rising yen vs. the U.S. dollar

Quantitative Easing

Quantitative easing has already ended in Japan. Quantitative easing simply means excessive printing of money by the Bank of Japan in order to defeat the deflation that has been raging for about 18 years.

I believe that ZIRP (zero interest rate policy) and QE (quantitative easing) prolonged Japan’s deflation, but for now, that is irrelevant. The key point is that both are about to come to an end. Proof of the end of QE can be found in the following chart, courtesy of Contrary Investor:

As you can see, money supply in Japan nearly doubled between 2001-2006. Hedge funds could borrow yen at zero percent and invest in the U.S. stock market; or gold; or silver; or, after all of these rate hikes, U.S. Treasuries and get 5%. The only real worry was the yen rising in value more than the return on other investments. With Japan unwilling to let the yen rise, players piled high on the carry trade.

From a U.S. dollar perspective, when interest rates were slashed to 1%, another possible carry trade was to borrow funds in U.S. dollars and invest in gold, silver, or equities. With the S&P dividend ratio under 2% and interest rates close to 5%, the U.S. carry trade slowly died with each rate hike.

Rising interest rates in Europe and Japan and falling rates in the U.S. (a global equalization of interest rates) will end more of these carry trades.

Contrary Investor points this out:

“Historical periods of meaningful rate of change decline in the Japanese monetary base have preceded each meaningful U.S. recession of the last three decades. Just eyeing them out, these large percentage drops occurred in ‘73/’74, ‘79/’80, 1990, and 2000. If, indeed, history has the chance of repeating itself ahead, what should we now be expecting for the macro U.S. economy as we look directly at current Japanese monetary base contraction?”

Speculation in various markets is extreme, as noted by trillions of dollars worth of derivatives floating around. The unwinding of those derivatives and any related carry trades is not likely to be a smooth event. In “Financial War Games,” I talked about the European Central Bank running “stress tests” to see if it could handle a derivative meltdown. We might just be put to the test. Clearly, we are at a serious crossroads of the greatest liquidity experiment the world has ever seen, with multiple players, in multiple countries, doing mind-boggling things with tremendous leverage.

Right now, we see the “Fed in a Quandary” about what to do. In spite of that, Bernanke thinks the Fed can magically control the global economy with a looming U.S. recession on top of a housing bubble bust. It is the height of hubris.

ZIRP

QE is toast. Let’s consider the end of ZIRP (Zero Interest Rate Policy). Bloomberg is reporting, “Yosano Says Japan Must Eventually Say Deflation Over”:

“Japan’s government will eventually need to declare an end to deflation, Economic and Fiscal Policy Minister Kaoru Yosano said.

“‘At some point citizens will need to be told by academics or politicians that sustained price declines have ended,’ said Yosano, who was speaking to lawmakers in Tokyo today. ‘Hardly any consumers are under the impression that prices are falling.’

“Japan’s core consumer prices have risen for the past six months, signaling the economy’s tussle with more than seven years of deflation is ending. Rising prices and an expanding economy may prompt the Bank of Japan to raise borrowing costs for the first time in almost six years as soon as July, economists say.

“Chief Cabinet Secretary Shinzo Abe reiterated separately that the central bank should keep borrowing costs near zero to support the economy. He said the bank and the government need to work together to end deflation and ensure prices don’t resume falling. Abe was speaking to reporters at a regular news conference in Tokyo today.”

For now, Japan seems unwilling to let interest rates rise, as evidenced by the Financial Times article “BOJ Injects $13 Billion Into Market to Cut Rates”:

“The Bank of Japan on Monday injected a massive Y1,500 billion ($13.3 billion) into the money market as it desperately sought to keep overnight interest rates under control.

“The injection came as overnight rates once again tested the 0.1% ceiling, calling into question the central bank’s ability to keep rates at ‘effectively zero,’ in line with its stated policy.”

The market is attempting to force Japan to hike. Japan is resisting. With a national debt of 150% of GDP, how much longer can Japan resist? A rising yen would be bad for those borrowing in yen and investing in U.S. Treasuries. A rising dollar is bad for those borrowing U.S. dollar and buying gold, silver, or falling U.S. dollar-denominated assets. The crosscurrents on some of these trades are significant, even though the yen and the dollar cannot both fall relative to each other. What can happen, however, is falling asset prices (stocks, gold, silver, copper, equities) at a rate greater than any interest rate differential. That is likely in a monetary tightening situation as we are seeing in both Japan and the U.S.

E.U. Money Supply

Writing for the Financial Sense Market Wrap Up on May 31, Paul Nolte had this interesting commentary:

“Many fingers are pointing to money supply (or lack of M3 being reported) as a key to the ‘blown-up’ U.S. economy. However, the reality points to places outside the U.S. The various Ms are running at relatively low year-over-year rates — MZM 3.9%, M2 4.5%, and M1 a measly 1.8%. This contrasts with the big inflation years during the ’70s and ’80s, when these aggregates were well over 10% (and sometimes north of 15%). Even the monetary base is growing at a 4% rate, less than one-third of the pace of the early ’90s. So where is the liquidity coming from? One place is Europe, where the European central banks are boosting money supply by a torrid 8% annual rate. While ‘Helicopter Ben’ may have a tough name to overcome in the months ahead, investors need to look elsewhere when complaining about excessive monetary growth.”

Bingo. Once again, “dollar bears” only point out what the U.S. is doing, forgetting about gross distortions in Japan, Europe, and the U.K. Long term, this is, of course, good for gold, but short term, the unwinding of various carry trades can wreck havoc on those that are overleveraged.

With that excessive expansion of credit in Europe, interest rates in the E.U. are poised to rise. Please be prepared to click off No. 3 on the list above if and when it happens.

Fed Cause

No. 4 is a given. The Fed at some point will pause. The unwinding of the housing bubble in the U.S. assures it. The question is when. The problem if it does not pause is that the blowup of the housing bubble will accelerate, and the problem if it does is a potential bond market revolt. Jobs here are the key. Falling jobs in conjunction with a housing bubble bust will let the Fed get away with a pause and subsequent cuts. This, of course, is where it gets complicated. Will Japan react to slowing U.S. demand by attempting to weaken the yen yet again? If internal demand in China and Japan picks up, Japan can perhaps happily keep hiking. If not, can Japan can abruptly end QE and go back to ZIRP to fight one more round of deflation? I think not.

Everyone talks about hyperinflation in the U.S. What happens to the Japanese if they stay on its current QE/ZIRP path forever? At some point, a national debt at 150% of GDP matters even if “they owe it to themselves.” It might seem funny to be talking about massive inflation in Japan, but under the right circumstances, I could foresee a loss of faith in the yen. Typically, emergence from K-Winter is a slow event with slowly rising inflation, but with central bankers everywhere taking all sorts of untried experiments with liquidity, some sort of major currency problem with the yen is possible. If the BOJ changes its mind about QE (something I do not expect), then a loss of faith in the yen is certainly possible. It is a scenario that is on virtually no one’s radar, yet it is not really that far-fetched (even if at this point it is unlikely). Yet everyone assumes the U.S. dollar will blow up. The contrarian in me suggests that if a huge currency problem of some sort emerges, it just may be elsewhere. Perhaps this scenario unfolds sometime down the road in a panic move by Japan to reinstate QE.

Credit Tightening

Let’s move on to No. 5. Is credit tightening in the U.S. so unlikely? I think not. All it takes to kick it off is accelerating housing declines. The ultimate nightmare scenario for U.S. housing would be a situation in which long-term mortgage rates decouple from the 10-year Treasury note and stubbornly refuse to drop in the face of easing actions by the Fed. I view that as a possibility that I have not heard discussed elsewhere. Rising default risk could potentially change mortgage lending standards in situations in which large downpayments are not made. Regardless of whether that specific scenario unfolds, consumer credit is showing signs of stress and money supply growth is far greater in the E.U. and China than it is in the U.S. In fact, money supply in China is up a staggering 22%, as noted in “9th-Inning Liquidity.” Falling home prices, falling jobs, and a correction of the negative savings rate in the U.S. is all that it will take for huge credit problems in the U.S. to surface. At this point, all three of those seem extremely likely.

A Rising Yen

Some have argued that with interest rates in Japan at zero, a modest rise in interest rates to 1% will not stop the yen carry trade. Borrowing at 1% in Japan get 4-5% in the U.S. — what could be simpler? I disagree. A rise in the yen greater than the interest rates’ differential would cause a loss for yen carry trade players. Assume for a second that rates fall to 4% in the U.S. and rise to 1% in Japan. At that point, the U.S. Treasury yield will still be over double the dividend yield on the S&P (a situation not that great for U.S. dollar carry trade players). And from the perspective of the yen carry trader, all it would take to wipe out profits would be a mere 3% rise in the yen. Notice that it would not take a collapse of the U.S. dollar to cause huge problems. A mere 6% move versus the yen would cause a tremendous amount of damage. I suppose one could try to hedge that currency risk, but ask yourself how well Fannie Mae has done hedging its interest rate risk. It may not be the easiest thing to do.

An additional problem for Japan is that a rising yen would hurt Japanese exports. That might not bode well for the Japanese stock markets. As long as Japan could slow the rise of the yen via ZIRP and QE policies, yen carry trade players had the green light to pour it on. That green light is now a brightly flashing yellow (possibly even red) given that every increase in Japanese interest rates will help fuel a rise in the yen.

There you have it: the nightmare carry trade scenario. All in all, it looks closer than anyone might have thought. Perhaps that is the message of a 100-point plunge in gold; copper going down lock limit several times; silver ramping to the moon; just to fall off a cliff; various emerging markets indexes plunging; and global equity markets taking a collective nose dive.

Should a nightmare unwinding of various carry trades unfold as I expect it to, “dry powder,” as in cold hard cash, just may be a good thing to have.

Regards,
Mike Shedlock ~ “Mish”
June 5, 2006

Nightmare Carry Trade Scenario was originally featured on Whiskey and Gunpowder