US consumer's insolvency, a catalyst of impact phase of the global systemic crisis

[EJ]

US consumer's insolvency, a catalyst of the impact phase of the global systemic crisis
November 17, 2006 (LEAP/E2020)

Extract of the GlobalEurope Anticipation Bulletin N°9

The American mid-term elections have now passed and, only a week later, as announced by LEAP/E2020 in GEAB N°8 of last October 15, the “euphorisation” of US voters/consumers and world financial players seems to have already passed with them. The development process of the global systemic crisis has resumed its course, artificially stopped last July due to the upcoming mid-term elections, as shown by the recent changes in the Dollar’s value and by the latest US economy indicators. In parallel, a series of topics which had curiously disappeared from the pages of financial media these last months is reappearing, such as the end of the “carry-trade” based on the Yen, increasing fears of the risk of implosion of the market for derivatives and “hedge funds” and of course the uninterrupted fall of US real estate with its procession of negative consequences on American growth (all these developments generating from now on increasing reflection as to the health of the US banking sector, one depending more and more on unsound debt). For the team of LEAP/E2020, all these trends, which mark the beginning of the impact phase of the global systemic crisis, have a common catalyst, and that is the insolvency of the US consumer in the framework of a generalized degradation of the quality of credit to all US financial and economic operators.

For the LEAP/E2020 team, it is from now on time to remove the ‘conditional’ from this scenario. It is currently happening throughout all the United States and constitutes a catalyst of the impact phase of the global systemic crisis. The US consumer, i.e. the US middle class, basically becomes insolvent, victim of overwhelming debt, a negative rate of saving, the bursting of the real estate bubble, the rise of interest rates and the collapse of US growth. All these elements are dependent, and mutually reinforcing, to plunge the United States, starting from the end 2006, into an economic, social and political crisis without precedent.

Very concretely, this November issue of GEAB sounds two “LEAP/E2020 Alerts”:

• The first relating to banking and finance sectors which, by the way of “hedge funds” and “bad quality credit”, will be at the centre of the impact phase of the global systemic crisis;
• And the other, which again amplifies the Alert published in GEAB N°4, relating to European real estate, with as an illustration, an analysis of the market trends of the British and French real estate.

AntiSpin: This morning I participated as a panelist at a forum "EuroStrategies for US Companies: Perspectives on International Finance and Corporate Finance," held at a MIT Faculty Club, Cambridge, Massachusetts. The audience was comprised mostly of European entrepreneurs, and a few local entrepreneurs, venture capitalists, and private equity folks.

When I talk about matters iTulip at these kinds of events, as with such events during the tech stock bubble 1998 to 2000, most react with a either disbelief or uninterest. But there's usually at least one member of the audience for whom the message rings true. After the panel and event were over, I was approached by a man who is close friends with someone who shall remain nameless who holds a relatively high level position at the IMF. The man who spoke with me is well known in the community. His IMF pal has been telling him the same thing as iTulip: that the dollar is an accident waiting to happen, but no one knows when, and that any central bank that supports it is on a fool's errand, delaying and worsening the outcome of an inevitable correction, and that the world's central banks should long ago have followed the markets' lead and allowed the dollar to fall, rather than face the risk of a disorderly dollar collapse as we do today.

As I mention in today's Quick Comment, Asian and European central banks are collectively making a mistake similar to the one that, paradoxically, the Fed made in the 1920s when it intervened to keep the pound sterling from falling and Great Britain's interest rates from rising, as the flow of captive capital from its colonies declined and it could no longer pay for its imports. In those days, they tinkered with domestic reserves to lower rates to match Great Brittain's. Today the trick is to buying US sovereign debt. It seems that what holds true for ex-colonies with important trade relationships with their once imperial rulers holds true for ex-communist countries that rely on export revenue from the US: they are reluctant to move on to develop more sustainable trade relationships, and put the entire global financial system at risk in the process.

While no one welcomed the news of my prediction of a recession in 2007, the point was made was that both Europe and Asia are in far better shape to withstand a US recession than ever before. From my upcoming conclusion of the Recession 2007 series...

[jk]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

the point was made was that both Europe and Asia are in far better shape to withstand a US recession than ever before.

i hope you will address this point at some length. when i have thought about this issue, my sense is that these economies are still too dependent on the consumer of last resort, the u.s. consumer, and that a sharp recession in the u.s. would quickly become global.

from bloomberg: [Chinese] Spending on goods and services by households and the government fell to 51.9 percent of GDP in 2005 from a revised 54.3 percent the previous year and 62 percent in 1978, the National Bureau of Statistics said in its latest annual statistical yearbook obtained by Bloomberg News....

Investment, expressed as capital formation, accounted for 42.6 percent of GDP last year, down from a record 43.2 percent in 2004, the report showed. It was the first time in five years that the ratio declined.
---------------


so chinese consumption is roughly half it's gdp. investment is enormous, and this investment is creating even more industrial capacity, along with construction, public works, etc.

but also

from http://www.manufacturingnews.com/news/06/0905/art1.html
During the first half of 2006, Chinese exports of manufactured goods reached $404 billion compared to $367 billion in exports by the United States.

from http://www.thetrumpet.com/index.php?...rticle&id=2693
China and Asia are becoming less dependent on trade with the U.S. China’s exports to America have fallen significantly—in 1999, they were 34 percent of China’s exports; today that figure is 25 percent (when adjusted for Hong Kong re-exports). Additionally, the European Union replaced the U.S. as China’s top trading partner in 2005. Similarly, the fraction of Asia’s exports to the U.S. has fallen from 25 percent to 20 percent over the past five years.
--------------


unless i am misunderstanding something, this implies that $200billion of production is exported by china to the u.s. annually. where will that production be absorbed if the u.s. is in recession and consumption drops? u.s. consumption will not drop to zero, of course, but those chinese factories need to be kept busy - i'm sure the communist party leaders will feel that way, at least. further, how will all that investment be directed if chinese exports are taking a major hit? and this doesn't address the issue of the state operated enterprises which continue to engage a lot of non-productive labor.

so, ej, please address this issue at length, as i would love to be cheered up.

[DanielLCharts]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

I agree with JK on this one. I think the "Eurozone and Asia will be fine" idea might be a big itulip whiff, along the lines of Marc Warner becomes president in '08 and US housing prices will only decline nominally and not in real terms in this cycle.

Economies and markets - both stock and housing - are now very much moving in lock step around the world. Yield curve inversions, granted of varying degrees, are sprouting up all over the world (UK, US, Aus, NZ, Canada, Germany, France) like zits on a teenager.

Theorize as you may, but in this cycle the US stock market has consistently reflected the lower beta trade, while the rest of the world is generally higher beta. When volatility has struck and pushed prices to the downside, the foreign markets have taken the corrections harder (South Africa, Brazil, Japan, India, UK. Australia seems to be a wierd exception, though). I doubt this cycle is going to change. If you think a deep recession is likely to hit the US, the rest of the world is probably going to get hurt too, and in terms of stock prices - probably worse off.

The degree of bullishness in Asia and Europe reminds me of the US in 2000.

[EJ]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

so, ej, please address this issue at length, as i would love to be cheered up.

The rest of the world will get hit hard, there is no doubt. The question is, how hard, what policy response can we expect, and what results are these likely to have.

The point is that we cannot assume that the next serious recession will be like the last. Our last recession in 2001 was mild, and relatively easily overcome with text book reflation policies - tax cuts, deficit spending, liquidity injections, and dollar depreciation followed by coordinated major currency depreciatio by global central banks.

To find recessions in the past that are equal in severity to the one I expect we have to look back to the early 1930s and early 1980s. The world was a very different place at both times than today. But then the world is not even like 2001 anymore–the reflation policies are still in place: particularly the budget deficits and tax cuts. What happens as we head into recession with oil still at $56 per barrel, versus $20 in 2001, and the only domestic policy lever left to the U.S. is to attempt to expand deficits further, expand credit further, depreciate the dollar more? The gold price is, in my view, giving us clues, because it is holding as the oil price declines.

China will have significant problems, but they will not make the same mistakes as Japan did and allow their currency to depreciate and their economy to fall into a deflationary recession. Further, China is a single party state. It will deal very differently with the political impact of a global recession than the U.S. A single party state has distinct advantages in a crisis; they can pursue policies that in the short term are politically difficult while in the long run will put them in a better position long term. The U.S., with its democratic Congress, appears in a position to take the short term political expedients which may make matters worse both short and long term such as raising trade and immigration barriers, repeating the main error of the 1930s.

Anyway, the hypothesis of the 2007 recession remains a work in progress, and will be pubished soon. Appreciate your continued interest and contributions to this forum and the iTulip community.

[jk]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

they will not make the same mistakes as Japan did and allow their currency to depreciate

re the yen. do you mean APPRECIATE rather than DEPRECIATE? the japanese markets peaked at the end of '89. for the next 5 years the yen was rising against the dollar.

[EJ]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

I agree with JK on this one. I think the "Eurozone and Asia will be fine" idea might be a big itulip whiff, along the lines of Marc Warner becomes president in '08 and US housing prices will only decline nominally and not in real terms in this cycle.

Economies and markets - both stock and housing - are now very much moving in lock step around the world. Yield curve inversions, granted of varying degrees, are sprouting up all over the world (UK, US, Aus, NZ, Canada, Germany, France) like zits on a teenager.

Theorize as you may, but in this cycle the US stock market has consistently reflected the lower beta trade, while the rest of the world is generally higher beta. When volatility has struck and pushed prices to the downside, the foreign markets have taken the corrections harder (South Africa, Brazil, Japan, India, UK. Australia seems to be a wierd exception, though). I doubt this cycle is going to change. If you think a deep recession is likely to hit the US, the rest of the world is probably going to get hurt too, and in terms of stock prices - probably worse off.

The degree of bullishness in Asia and Europe reminds me of the US in 2000.

It was silly to try to guess the outcome of the 2008 elections. The error was to allow hope to leak into my analytical framework. It's helpful to be humbled by the vicissitudes of the political process–sharpens the wits. I will not make any more specific political predictions, but will stand on my record of economic and market prognostications–one each, not a stopped clock repeating the same prediction until true–which, while imperfect–I am glad to compare to anyone's:

November 1998: Warns of Internet Bubble
August 1999: No Y2K Disaster
November 1999: Explains How Internet Bubble Will End
March 2000: Calls Internet Bubble Top
January 2001: Call Post-Bubble Recession
September 2001: Calls Gold Price Bottom at US$27
August 2002: Warns of Housing Bubble
January 2004: Explains How Housing Bubble will End (Drop in Transactions)
January 2005: Explains Housing Bubble Correction Dynamics - Timing
March 2006: Explains Housing Bubble Correction Dynamics - Geographic
June 2005: Calls Housing Bubble Top
October 2006: Warns Gold was Not Yet a Bubble when it hit US$720

Of these, the most difficult was the 2001 post-bubble recession call. At a time when others were debating whether or not we'd have a recession, I was attempting to characterize it. This was ambitious. The variability of inputs and randomness of events that influence the outcome makes macro-economic prediction very hard. The objective is not to make a perfect call as in market timing, but to make a "good enough" prediction, and better than others'. I did well enough that I was later able to extend the analysis to make my Sept. 2001 gold call and a significant investment in gold very near a 20 year bottom when "deflation" was the word on everyone's lips and gold was considered a terrible place to put your money.

Characterizing a 2007 recession today is an even more ambitious undertaking than characterizing the 2001 recession in late 2000. The recessionary forces will be much greater than following the tech bubble collapse, the policy options more restricted, the geopolitics far more complex. There was, for example, no War on Terra in January 2001. Oil was $20/bl not $56. Home equity had not yet been cashed out.

I doubt the Fed knows this yet, but what I call a "managed hyperinflation" of the "Poom" period may be, by design or a conituation of current policy backed into, the only viable option. At least that is the working hypothesis, and I welcome your criticisms of it.

[EJ]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

re the yen. do you mean APPRECIATE rather than DEPRECIATE?

Yes, appreciate not depreciate.

[jk]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

the yen appreciated about 85% [yikes!] against the dollar between the bottom in 1990 and the spike top in '95.

it is easy to imagine the chinese allowing the yuan to appreciate a few percent a year against the dollar, trying to hold off protectionist pressures, while the dollar itself is dropping. who's the old maid? looks like the euro and maybe, to a lesser degree, the yen.

re: the yen. if the dollar is in the process of dropping the yen carry trade becomes less attractive. as the fed is lowering rates, that creates even more pressure to unwind the yen carry trade. players unwinding yen carries will put further upward pressure on the yen, so you get an amplifying feedback loop. the japanese have increasing exports to china which they will not want to jeapordize anymore than they want to kiss the [somewhat shrunken] u.s. market goodbye. so the boj might hold down the yen's rise by buying dollar instruments.

so i can imagine the dollar dropping, the yuan dropping a bit less quickly, and the yen following the yuan. the chinese and japanese will be expanding their own money supplies rapidly in the process. [god knows if any of this will come to pass, but i'm trying to think out loud here.]

i don't foresee the ecb buying treasuries, so the euro is the old maid.

[bart]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

The rest of the world will get hit hard, there is no doubt. The question is, how hard, what policy response can we expect, and what results are these likely to have.
...

Indeed. One of the few things with which I agree with Bernanke on is the broad statement that actions will be data dependent.

It doesn't appear to me at this point that the US recession will be terribly severe (ala the early '80s or '30s), mostly due to the overall money picture and how it's different than 2001. Here's the overall money & credit picture, with all numbers except GDP advanced 18 months to account for a "normal" monetary lag.



As can be seen, there is an acceleration due to hit in early 2007 to help counteract the negative influences we see now. Both M3 and credit move into a high range. Also, monetary base has not been subject to the huge expansion like what occurred from 1995-2000 and will therefore not have to go through the large ups & downs of 2001-2.

This is not at all to say that things will not be very negative for very many people, just that my best current guess is that the recession will not be terribly deep.

Here's another perspective - rates of yearly change for credit creation that show the relative success that the Fed & gov't have had keeping credit creation going at a fairly high rate for many decades. Note that I'm not condoning it, simply offering it as a long term perspective along the lines of "it's not hugely different this time".





On the China situation, someone observed above that their exports run about $400 billion per year. Just for purposes of discussion, let's say that drops 50% or $200 billion - that "only" roughly drops China's GDP growth rate from its current 11%+ rate to about 5% (China's GDP per the IMF is about $2.9 trillion now), and that's still quite a respectable growth rate. India would be similar but Japan will likely get hit much harder due to its relatively weak economy. I'm looking for the Nikkei 225 to fall to at least 13,000.

The European area is more difficult since I'm still very much mid stream on my data gathering and analysis... but I will observe that their money supply and credit growth has been very roughly similar to the US for the last few years. The main differences are their currency strength and their overall balance of payments being in good shape - none of which is surprising to anyone who has been watching for a while. The bottom line is that I'm expecting less of an effect on the Euro economy area overall than in the US.

[DanielLCharts]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

ah, this does much to clarify what you wrote earlier regarding the impact of the recession. I misunderstood your message as one that anticipated smooth-sailing for non-US economies. How does the recession of '74 stack up as an analog for what is fast approaching?

The rest of the world will get hit hard, there is no doubt. The question is, how hard, what policy response can we expect, and what results are these likely to have.

The point is that we cannot assume that the next serious recession will be like the last. Our last recession in 2001 was mild, and relatively easily overcome with text book reflation policies - tax cuts, deficit spending, liquidity injections, and dollar depreciation followed by coordinated major currency depreciatio by global central banks.

To find recessions in the past that are equal in severity to the one I expect we have to look back to the early 1930s and early 1980s. The world was a very different place at both times than today. But then the world is not even like 2001 anymore–the reflation policies are still in place: particularly the budget deficits and tax cuts. What happens as we head into recession with oil still at $56 per barrel, versus $20 in 2001, and the only domestic policy lever left to the U.S. is to attempt to expand deficits further, expand credit further, depreciate the dollar more? The gold price is, in my view, giving us clues, because it is holding as the oil price declines.

China will have significant problems, but they will not make the same mistakes as Japan did and allow their currency to depreciate and their economy to fall into a deflationary recession. Further, China is a single party state. It will deal very differently with the political impact of a global recession than the U.S. A single party state has distinct advantages in a crisis; they can pursue policies that in the short term are politically difficult while in the long run will put them in a better position long term. The U.S., with its democratic Congress, appears in a position to take the short term political expedients which may make matters worse both short and long term such as raising trade and immigration barriers, repeating the main error of the 1930s.

Anyway, the hypothesis of the 2007 recession remains a work in progress, and will be pubished soon. Appreciate your continued interest and contributions to this forum and the iTulip community.

[jk]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

On the China situation, someone observed above that their exports run about $400 billion per year. Just for purposes of discussion, let's say that drops 50% or $200 billion - that "only" roughly drops China's GDP growth rate from its current 11%+ rate to about 5% (China's GDP per the IMF is about $2.9 trillion now), and that's still quite a respectable growth rate.

bart, the figure was $404billion in the first half of 2006. also, i'm not sure you can calculate the effect of an export slowdown in the way you do. if you assume that $xbillion worth of exports are not produced, yes, that reduces gdp by that same figure. more likely is that the factories keep producing some of that output, but prices drop. simultaneously there is a back up in the investment stream. remember, over 40% of gdp is going to investment. is anyone going to be building new factories in this scenario?

[jk]

will the euro be the old maid?

from stratfor:

As is typical for French leaders, Prime Minister Dominique de Villepin spoke his mind in a Nov. 11 interview, this time by challenging the independence of the European Central Bank (ECB), the institution responsible for Europe's common currency and monetary policy.

Specifically, de Villepin challenged the ECB's authority to set policies that affect exchange rates and interest rates, warning that current policies hurt exports. Europe, he said, needs a "monetary shield," implying a desire for a weaker euro in order to strengthen the competitiveness of European (meaning French) exporters....

...many French leaders are beginning to second-guess not only France's rationale for being in groupings like the eurozone, but even in organizations like the European Union.
--------------------------

stratfor has long questioned the long term viability of the euro. it looks like the euro will be the old maid [the strongest currency, thus producing the most suffering], or perhaps there will be no euro at all.

[metalman]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

danny and bart... chart dudes. any take on the itulip housing permits chart?

[bart]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

bart, the figure was $404billion in the first half of 2006. also, i'm not sure you can calculate the effect of an export slowdown in the way you do. if you assume that $xbillion worth of exports are not produced, yes, that reduces gdp by that same figure. more likely is that the factories keep producing some of that output, but prices drop. simultaneously there is a back up in the investment stream. remember, over 40% of gdp is going to investment. is anyone going to be building new factories in this scenario?

I wasn't trying to do something terribly precise with that example, just show that it wouldn't be a terrible effect. I do know that exports run about 20% of their GDP... and also that just a very few years ago it was almost 40%. Its also extremely unlikely that exports would drop 50% so my rough example holds. They've also been making huge strides towards internal consumption and a consumer economy, plus have that trillion in reserves to keep things "fertilized".

I'm fairly sanguine about China and not much concerned
about a slowdown in factory building etc. There is a gigantic amount of infrastructure that still needs building too.

[bart]

Re: US consumer's insolvency, a catalyst of the impact phase of the global systemic c

danny and bart... chart dudes. any take on the itulip housing permits chart?

I'm not sure what you're looking for, but I pretty much agree with EJs take* - the effects will not be pretty for many people and will have a larger effect than most think on the economy. Housing may bounce over the next few years on a face value basis, but not on an inflation adjusted basis.

Here's a housing chart I put together a while ago, showing both CPI and CPI+lies (shadowstats.com adjustments) median new housing prices since 1963. It rather illuminating - note that both CPI adjusted prices are on the right hand scale.




* (or EJ agrees with mine ;))