All week we’ve been talking about the big, long-term, generational trends taking place in the economy and in financial markets. Bonds are in a bear market. Residential real estate in the Western world is in a bear market (including Australia, we’d contend). Commodities are in a long-term bull market because of decades of underinvestment in productive capacity and a surge in demand from the developing world. But they are still dusting themselves off after getting blindsided by last year’s collapse in global trade.
Today we’re going to have more to say about common stocks. Some are up. Some are down. Commentators are talking about new highs on the major indexes. And over in America, the S&P 500 made a seven-month high and closed at its highest level since November 5th of last year.
Nice work S&P. Take a bow.
The catalyst for yesterday’s rally may have been that $11 billion 30-year Treasury bond auction the market has been dreading all week. It went better than expected, apparently, meaning the auction didn’t fail. That said, the 4.72% yield at the auction was the highest at a 30-year auction in two years.
Investors are demanding higher yields to loan for ten and thirty and years to debtor governments. But we think the bond vigilantes must be going soft. Someone hand them a crow bar. According to data from Merrill Lynch, 30-year U.S. bonds are down 28% this year. Ten-year notes are down 11%. And even the two-year notes-widely thought of as a near-cash bastion of government-guaranteed safety-are down 0.4%.
Losing your capital and getting killed by inflation isn’t really that “safe” is it?
Speaking of losing capital, what is Federal Treasurer Ken Henry getting on about? Has he formed a raiding party destined for your super annuation assets? Today’s Australian reports that Henry, “has established a departmental review to examine ways in which the superannuation savings pool can be directed to seed new markets and target specific areas, such as corporate debt and infrastructure.”
What does this have to do with losing capital? The government is always after your money. Everyone knows that. But if the Aussie government manages to persuade/sucker/coerce the superfund industry to invest in the government’s priorities, it will be an evolution in the kind of government-managed capital market we seem to be heading towards anyway. We’d suggest it is not a good sign for the safety of your retirement assets.
Super funds represent a pool of capital the government doesn’t have to borrow on the international bond market. Of course, technically the super money is your money. But if Henry is up to what we think he’s up to, your money could soon be financing government-backed infrastructure projects or participating in corporate bond auctions.
You can imagine the super industry would do these things anyway, if they seemed like good investments. But this latest development highlights a problem for both the industry AND the government. It’s also a problem for Australian investors if money expected for retirement is invested in boondoggles or bad corporate bonds.
For the superannuation industry, the bigger problem is that the generational bull market in stocks is over. There are still sectors and industries that will do quite well and that fund managers can profit from. But finding them and managing to get capital into them at attractive prices is going to be a lot harder. People might actually have to work for a living and even think, rather than just clipping tickets and surfing a bull market higher.
For the government, the money in superannuation funds must be irresistible. There’s just so much of it. And gee, it’s not really doing anything productive is it? If there were only a way to commandeer it legally that didn’t look like, you know, theft. Stay tuned. We’ve asked resident super analyst and over-all guru Kris Sayce to comment. More from him Monday.
This brings us to another of those long-term trends that you are probably already aware of, but which we’ll point it out anyway. People in the Western world are getting poorer. It might not look like that, with high standards of living and per capita incomes (which are not, by the way, the same as a high quality of life). But there’s no doubt that globalisation has led to wage deflation for most Western workers, especially in manufacturing but increasingly, also in services and white collar jobs.
Yep. It’s just a much more competitive world out there. And during the credit-backed boom years (really beginning in the post-World War Two years), it meant consumers were spoiled for choice with products imported from around the globe and available at relatively cheap prices.
But remember, the one factor that’s left out of all economic calculations is what’s unseen. Lower prices for consumer and manufactured goods was a tangible benefit everyone could enjoy. What was unseen was the ultimate cost of shifting production off-shore and reorienting the economy to the financial industry and residential housing. It is now being “seen” in the way a fist to the face is seen…and felt.
The ultimate cost is that most people in Western industrialised economies are getting poorer. The deindustrialisation and off-shoring orgy of the last twenty years shifted productive real assets to the developing world. It lowered real wages (adjusted for inflation) as the structure of the job market shifted towards retail, housing, and consumption and away from manufacturing and production. It also lowered savings rates as people mistook easy credit and asset price appreciation for permanent prosperity.
This cost was not apparent in the last ten years of the boom when asset prices went to the stratosphere. People appeared to be getting richer with rising home values and stock portfolios. They may have been income poor, but they were asset rich.
On the downside of the credit cycle, people are now finding out how phony the boom was. Most of the gain in U.S. home prices over the last ten years was simply inflation-funny money financing a mortgage boom that led to a price bubble. Now, asset values are falling. Net worth is falling too.
According to data published yesterday by the U.S. Federal Reserve, total household net worth fell by $1.3 trillion in the first quarter of this year, from $51.7 trillion to $50.4 trillion. The scary thing is that the first quarter drop was actually an improvement on the fourth quarter number, in which net worth fell by $4.9 trillion as the stock market crashed.
For the record, we have no idea how the Fed manages to conjure these numbers, or whether they are anything close to realistic. But let’s pretend for a moment they are legitimate and examine them in just a bit greater detail. Even though these are American numbers, we think they illustrate the same basic point for most Western countries: the credit cycle has left us asset poor and debt rich.
Let’s take 2002 as a starting point. It’s a bit arbitrary. But it was just after the long-term peak in stock markets and just the beginning of the commodity bull market.
Interest rates had been lowered globally in response to 9/11. And the debt boom that led to, among other things, the American mortgage boom, was on. The U.S. mortgage boom was, of course, the origin of all the securitised and collateralised assets that have brought the global financial system to its knees.
In 2002, total U.S. household debt was “just” $8.5 trillion. Six trillion of that was mortgage debt and $2 trillion of it was credit card debt. Over each of the next four years, U.S. households grew their debt at double-digit rates. By 2007, total household debt had grown to $12.9 trillion , $10.5 trillion of which was mortgage debt and $2.4 trillion in credit card debt.
So if you’re scoring at home, mortgage debt grew by 75% in that five-year period and credit card debt grew by 20%. Overall, household debt grew by 51% in five years, from $8.5 trillion to $12.9 trillion. And what did the economy have to show for all that debt?
Well, probably not as much as people expected. But in 2007, it looked like a good deal. The 51% increase in debt was exceeded by a 54% increase in household net worth (from $40.4 trillion in 2002 to $62.5 trillion in 2007). That doesn’t seem a lot of bang for your borrowed buck. But can you really put a price on confidence and the feeling of being better off?
Since the peak in 2007, and since the onset of the Credit Depression, household net worth has fallen by $12.2 trillion, or 20%. Over half that fall has come from falling equity prices, where household equity holdings fell from a peak value of $16.7 trillion to their current value of $9.3 trillion. The bad news is that a second wave of foreclosures on alt-A and Option ARM mortgages probably means even lower U.S. house prices and a bigger fall in net worth.
We’re not reciting this litany of depressing news to be depressing. But it’s simply not a point made often enough in the financial media or by professional politicians: this economic model of stacking on the debt to buy assets doesn’t make people richer. The assets inevitably fall in value when the credit stops flowing, while the debt remains.
That’s where we are today. And that’s why we think the case is getting stronger that inflation is on the horizon. It’s the most likely way out of the debt, aside from actually paying it off and increasing savings. Economist Arthur Laffer agrees.
Laffer warned that the huge growth in the U.S. adjusted monetary base is bad news for investors everywhere. It is an American policy with global repercussions. Writing in the Wall Street Journal, Laffer says that, “The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10. It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless…
He says that, “It’s difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed’s actions because, frankly, we haven’t ever seen anything like this in the U.S. To date what’s happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5%.”
Naturally, this is horrible news. But what should investors do? Avoid bonds. Fixed-income investments get hammered with inflation. Take a look at investments that rise with inflation, like oil for example. Crude futures went over $73 in NYMEX trading on Thursday. And did you see what British Petroleum reported in its 2009 Statistical Review of World Energy?
BP reported that for the first time in ten years, global proven oil reserves have fallen. Naturally, you don’t find what you’re not looking for. But this little number confirms the idea we presented in our “Long Aftershock” report. Namely, the capital spending collapse in the oil industry in 2008 is going to lead to a supply shortage in the coming years. When this fact collides with recovery in demand growth, you will see much higher oil prices.
Alexei Miller, chairman of the Russian’s energy behemoth Gazprom, said he’s standing by his company’s estimate that oil will soon reach $250 a barrel. “This forecast has not become reality yet,” Miller told the Guardian, “given that the [credit] crisis gained momentum and exerted a powerful impact on the global energy market. But does this mean that our forecast was unrealistic? Not at all.”
The decline in proven reserves doesn’t mean the world is going to run out of oil next year. But investors would want to factor it in to their stock selection in the energy sector. Companies that haven’t slashed exploration budgets are more likely to find oil because…well…because they are still looking for it and growing their reserves. Companies not adding to reserves are going to sell current production at today’s prices and forego higher prices from future projects.
There are other variables, of course. You have to control costs. There’s political risk, too. There’s probably plenty of oil to be found in Africa. But doing business there will be another matter. And of course, what about demand? Can you really have another wave of global asset deflation without an impact on global trade and economic growth? Won’t oil demand stagnate if the world is swept into more deflation?
No one knows. That’s the unsatisfying truth. We did read yesterday that Chinese fixed asset investment was up nearly 33% in the first five months of the year compared to last year. The data from China’s National Bureau of Statistics gives analysts hope that China’s resource-driven investment agenda is enough to pull the globe out of its doldrums, or at least keep Australia out of recession.
It’s impossible that China alone could save the world. But then, that’s the reality no one wants to discuss, isn’t it? What if there is no saving a generation’s worth of bad investment in residential and commercial property? What if households, banks, and institutions that own trillions worth of debt-backed securities simply have to take losses? What happens then? What should investors do?
For stocks, the next ten years are hazy. The world’s balance of economic power is shifting. We already know who the big losers are. Ahem. And the winners? More on them-or more specifically, how to be one of them-next week. Until then…
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