Welcome to Credit Writedowns Pro. This is the first post in a series here. If you’re reading this post, I suspect it’s because you signed up for my newsletter and the Credit Writedowns Pro Gold membership since this post is behind a paywall. I still haven’t figured everything out so I am sure there will be bugs in this. If you find any, contact us at [email protected] so we can get the kinks out.
On the same note, I still haven’t figured out what to make of 2012. Is it a transition year and if it is, a transition to what? As I have been saying for two months, I am looking forward to writing this because I can tell you exactly what’s on my mind and have frank conversations with you in a more private environment. So hopefully, it will all come together in this post.
Here’s the story: the floating exchange-rate non-convertible fiat currency system that we have developed is a credit demand driven system with no natural checks on money creation. This system has spun entirely out of control due to elevated private sector indebtedness. The crisis we are living through now is the culmination of an over forty year process driven by the inflationary heart of our present monetary system. It was unsustainable from the start and has only held together because the interest rate supercycle allowed us to accumulate more and more private sector debt.
We are at the end of the line now with rates about as low as they can go around the developed economies. And so the debt accumulation issues are coming to a head, with the most vulnerable actors on the hot seat, in both the public and the private sector.
Just over two years ago I told you that the recession is over but the depression has just begun. My thesis then, which is playing out as i said it would is that governments would try to paper over the debt problems by bailing out the private sector actors, principally banks and heaping the debt burdens onto the public sector’s balance sheet. However this risk transfer is unsustainable as the debt problem is now so large that it can only be solved by writing down credit. And because the public sector has now socialised the losses, I predicted in April of 2010 that the origins of the next crisis would be a government debt crisis as both private and public sector attempted to deleverage at the same time.
That’s where we are. 2009 and the beginning of 2010 were the re-building period, the Fake Recovery years in which it seemed as though the fix was in. But by 2011, these illusions were shattered by the ever-widening European sovereign debt crisis. The question then is what happens in 2012. I don’t have the answers but this post puts what I think are some of the answers out there for you.
You know what, let me do this Byron Wien-style and make a predictions list. Wien defines his surprises as events to which investors assign 1-in-3 odds of happening but which he believes have a more than 50 percent likelihood of occurring in 2012. I thought his list was pretty pedestrian this year, a combination of bullish bias and relatively safe bets by someone chastened by the last few years of crisis. I don’t want to go out on a limb either but I hope my list is less safe.
- Greek investors finally take their writedowns: The latest from Europe is that policy makers believe even mentioning writedowns has created the crisis when in fact the crisis was going to occur anyway. The euro should never have existed because the euro zone doesn’t have an institutional framework to deal with economic crisis. Now the day of reckoning is at hand. And while the ECB has finally done what I told you they would and monetise sovereign debt, some directly and some via its three-year long term refinancing operation, this won’t be enough to stop the crisis without writedowns. So things will come to a head for Italy and that will force the Greek issue. That’s bearish for European bank stocks.
- Romney will be elected President: when you look at one-term post World War II US presidents, usually an economic downturn killed them. The sixty Go-Go years were as much a problem for Johnson as Vietnam. Ford and Carter had stagflation and Bush 41 had the first jobless recovery. The Republicans can’t win if the economy holds. Obama has to hope 2012 will be good and I don’t think it will be good enough because he is unlikely to have won over many new voters through his policies but is likely to have lost some through low voter turnout apathy or defection because of his imperial-style anti-civil liberties approach. So this is about Obama and not about Romney. The Republicans cannot win with anyone else unless the economy tanks because the other Republican candidates are too far right of center and will drive up Democratic voter turnout and drive away moderates. Only Romney is moderate enough to win.
- China will have a hard landing: I have a tough time on this one. But in keeping with the 50% odds when everyone else gives it one in three, I think China is the big story here. People who aren’t in the thrall of the China bull story know that the malinvestment there has reached breathtaking proportions. And with a second synchronised global growth slowdown in the last five years forming, China will get hit just as its over-investment bubble is popping. There are only so many losses it can socialise while its export and banking sectors are hit at the same time. The stimulus won’t be enough to prevent quarterly growth from stalling to say 5% annualised by the end of this year. That is China bearish given that stocks are already in a bear market. The additional real economy slowdown will hurt profits and sentiment, taking P/Es down with profits for a double whammy.
- India will be worse than China: Again, this is a tough one. Reports I hear from what’s happening on the ground in India are generally bullish in that people are telling me domestic consumer demand is still exploding higher. Yet, you have people like Christopher Wood cutting their forecasts from 7% to 6% growth. I think the cuts will be greater as the year unfolds. India has a balance of payments and currency problem that the other BRICs don’t. And like Brazil and China, the Indian Sensex was down big time in 2011. The only reason it rebounds is because of expanding multiples or expanding profits. yet India’s growth forecasts are being cut. So how do you get to expanding multiples or profits in that environment. You don’t?
- Australia’s housing bubble will pop: I was just thinking about this in the context of Ireland. Ireland has seen prices in Dublin fall 65% peak to trough. That’s enormous, Japanese-style asset price deflation. No wonder Ireland is in a depression. In 2005, when the housing bubble was at peak, Irish house prices were up 192% in the previous 8 year period, second only to South Africa in developed economies surveyed by the Economist. By comparison, Australian house prices were up 114% putting them behind only South Africa, Ireland, Britain and Spain. I can’t speak to South Africa but those other bubbles have popped while house prices in Australia have climbed higher on the back of Chinese over-investment. if you think China will slow, as I do, that makes Australia extremely vulnerable – and makes its house prices and Australian shares vulnerable too.
- European equities will outperform: you may have seen people like Jeffrey Gundlach saying that US-based investors want to stay with dollar based assets. What he was saying is that the euro is vulnerable to serious depreciation. I have been saying for a while that the ECB would backstop Italian (and Spanish) debt because the alternative is too grim. This is what’s happening now. That is euro-bearish in my view, just as Gundlach says. But if you avoid bank stocks, it can also be equity bullish. Barclays said last month that European Cyclically Adjusted P/E (CAPE) multiples are at their lowest since the 1980’s. And we know that there is a big multiple gap to the US from what Niels Jensen wrote in October. To me, that’s bullish – at least on a relative basis. Even if things come to a head in a negative way, why would you think European shares would decline more than US shares? For US investors, the risk is the currency. Europeans want to be overweight high quality, non-bank European shares.
- US real GDP growth is below 3% and while unemployment does drop, it rises again. This is just an anti-Wien prediction who said exactly the opposite. I’m not sure what his reasoning is for anticipating 3% US economic growth during a synchronised global growth slowdown but it doesn’t make any sense to me. Especially when he says oil is going to fall to $85 a barrel. I don’t see it.
- German GDP growth weakens significantly: As I have been saying for two years, I don’t see how you get a recession in Spain (or Italy) as well as elsewhere in the periphery and in France and Belgium now without Germany faltering. remember, industrial production in Germany is already shrinking along with everybody else’s. And austerity will take a toll around the euro zone. How does Germany avoid this downturn. They don’t. In fact, you could make the argument that if recession goes global via a US slowdown, Germany would be more vulnerable to a wild downswing just like Japan because of its mercantilist economic paradigm.
- Gold continues to lose its luster: gold wins when financial repression, defined as negative real interest rates, is the greatest. The higher the gap between inflation and long rates is, the higher gold will go because it goes from being a burden that has zero yield to being an asset that holds purchasing power amid government-sponsored wealth destruction. I think the inflation cycle has peaked. European inflation is coming down, Indian inflation and Chinese inflation are coming down. And policy rates, particularly in the US and Europe have no room to go much lower. That’s not gold bullish.
- The ECB becomes more explicit about its backstops: As I write this, Italian interest rates are now edging over 7%. The question, especially when the Italians have to roll over so much debt, is how do they continue on in that environment? The answer is they can’t. If Italian yields stay at 7% for too long, everyone not just some bond investors will start to believe they are essentially bankrupt. That gets you into Greece territory. Bottom line: the ECB will then face a stark choice. Make their Italian backstop more explicit or go through a debt deflationary and depressionary crisis and cease to exist as an institution as the euro unwinds. I think they will choose inflation.
That’s it. it’s done. Credit Writedowns Pro’s first issue is now officially written. It wasn’t ultra-controversial but i hope it was informative. I am already in the process of setting up a few forums on China and the euro zone to discuss some of these ideas. Join me. I look forward to the conversation.
Many thanks for your support. I wish you and your family a happy and productive 2012.
Edward
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