Absolute ZeroIn This IssueAbsolute Zero 1As in the physical world of absolutezero, near-zero interest rates create anew set of relationships that fewforecasters and policymakers fullyunderstand.The Fed and other central banks' near-zero rates are reactions to the globalfinancial crises, deep recession andcontinuing private sector deleveraging.The ineffectiveness of zero ratesspawned unfamiliar and ineffectivequantitative easing that threatens Fedindependence. At zero federal funds,the Fed can't cut with the nextrecession. And if deflation unfolds, itcan't get real rates to stimulativenegative levels.Low interest rates and the flat yieldcurves are hurting banks, forced fromprofitable speculative activities back tobasic spread lending. In the strangeworld of zero short rates and theuncertainty surrounding them, theTreasury downgrade sired leaps insafe-haven Treasurys while stockstanked. And this world reinforces therealization that we're in The Age ofDeleveraging where monetary andfiscal policies can't restore rapidgrowth.In this atmosphere, the dash to cash haspushed interest rates negative.Investors are abandoning troubledEurope for Treasurys. Low financingcosts benefited safe havens gold andthe Swiss franc as well as the high-yielding Brazilian real and Australiandollar. Commodity speculation is cheap.Trivial interest returns have mauledsavers who may have to work longeras well as pension and insurancecompany portfolios while encouragingdebt refinancing and century bonds.They also make government debtscheaper to finance and slow the rate ofdebt growth.Japan isn't a good model for the U.S.'simpending decade of slow growth anddeflation, but does suggest that the onlyway out of the world of zero rates is towait for The Age of Deleveraging to runits course.
Investment Themes 22Summing Up 23
Commentary—Family Vacations 40
September 2011
In its written release after its August 9 Federal Open Market Committee policymeeting, the Fed included a statement that was highly unusual because of itsspecificity. “The Committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflationover the medium run—are likely to warrant exceptionally low levels for thefederal funds rate at least through mid 2013.”
In the recent past, the Fed has stated its plans to keep rates low for an “extendedperiod,” but we can’t recall the central bank ever being this precise on any policy.The statement was also significant because it means that unless the economytakes off like a scalded dog, the overnight federal funds rate will continue closeto zero, its absolute bottom. Not surprisingly, longer term Treasury ratesdropped on the announcement. The 2-year note yield fell to 0.185%, an all-timelow, and the 10-year note yield hit 2.033%, below the previous 2.034% lowreached on Dec. 18, 2008, after the collapse of Lehman Brothers drove investorsto the safe haven of Treasurys. The June 2012 eurodollar futures, which we holdin managed portfolios, leaped by nine basis points, a huge one-day move (Chart1, page 2).
Not Alone
The Fed is not alone in keeping central bank short-term rates close to zero (Chart2, page 2) in response to sluggish and declining global economic growth and theinability of massive monetary and fiscal stimuli to revive economic activity. Theoutlier among major central banks is the ever-inflation wary European CentralBank, the spiritual descendant of the German Bundesbank and based inFrankfurt, Germany, for good reason. The ECB raised its target rate in Apriland again in July to 1.5% in response to Eurozone consumer inflation above its2% annual rate target for the overall index (Chart 3, page 2). Nevertheless, ECBPresident Trichet apparently has put further increases on hold and may later cutits rate in response to unfolding weakness and persistent financial turmoil inEurope, as explained in “The Eurozone Crisis and Possible Solutions” (Aug. 2011Insight).
Volume XXVII, Number 9 September 2011
(Apologies for the delay in delivering this Insight report. The East Coast hurricanein late August caused power outages in our office that took some time to rectify.)
Economic Research and Investment Strategy
A. Gary Shilling’s INSIGHT
2 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
Zero interest rates are significant forseveral reasons. Zero is the floor belowwhich rates normally don’t fall, althoughthe 3-month Treasury bill rate recentlywas negative amidst investors’ madrush for liquidity and the safe haven ofgovernment paper. More importantly,at zero interest rates, strange thingshappen in security, currency andcommodity markets that don’t fitnormal rules. This doesn’t mean thatactions are illogical and don’t followrational behavior, but rather that therules of difference. Most observersdon’t understand thoroughly the newnorms, their causes and effects. Mostsignificantly, central bankers and fiscalpolicy managers don’t seem to either,which makes forecasting the outcomeof their actions and the unintendedconsequences extremely difficult.
Low Temperatures
In our Jan. 2011 Insight, we drew theanalogy between interest rates near zeroand temperatures near absolute zerowhere all activity of sub-atomic particlesceases. Years ago, I was a physics majorat Amherst College, and a number ofthe physics professors and physicsmajors (but not me) were studying lowtemperature physics. Absolute zero is0o on the Kelvin scale, -273.15o Celsiusand -459.67o Fahrenheit—pretty cold!Near that temperature, strange thingshappen. Thermal energy arises from the motionof atoms and molecules as they collide,but at low temperatures, they don’t andatoms act identically like a single superatom. Substances that are magnetic athigher temperatures becomenonmagnetic, and vice versa. Somenonconductors become superconductors—that ’s why somecomputers are kept very cold. Othersbecome super fluids that seem to defygravity by crawling up the sides of theircontainers. Near absolute zero, a gasbecomes a super liquid that can leakthrough solid objects. The thermalconductivity of copper is very low nearabsolute zero, but leaps as the
,
CHART 3Eurozone Harmonized Consumer Price Indices
Source: Eurostat
Last Points 7/11: total 2.5; core 1.2year/year % change
You’ll probably recall how the Fed gotto its current federal funds target of 0-0.25%. In early 2007, the subprimeresidential mortgage market started tofall apart, as illustrated by the collapse inthe ABX BBB- Index (Chart 4). Severalmonths later, two billion-dollar BearStearns hedge funds, which were loadedwith subprime-related securities,essentially sunk that firm and forced ashotgun merger with JP MorganChaseBank. In August, the Fed cut its discountrate and the federal funds target rateshortly thereafter, initiating the declinesthat resulted in the current levels (Chart5). Other short-term rates followed, asusual (Chart 6)
Nevertheless, as Wall Street continuedto implode, it became apparent thatlower interest costs would not forestallthe market-forced deleveraging of vastlyoverleveraged financial institutions hatfew investors trusted with their money.So the Fed embarked on a series ofspecial measures to do much of thefunding that the commercial andinvestment banks normally take care ofthemselves. Chart 7 (page 4) lists sevenspecific actions, reported in our June2008 Insight, which paved the way fortwo rounds of quantitative easing later.
In 2008-2010, in what became knownas QE1, the Fed bought $300 billion inTreasurys, $1.25 billion in residentialmortgage-related securities and $100billion in Fannie Mae and Freddie Macsecurities in an attempt to further propup the faltering housing market andreduce mortgage rates. But these effortswere of little aid to the housing market,and prices resumed their decline inmid-2010 (Chart 8, page 4) after theeffects of the tax credits for new homebuyers expired. So, at the Jackson Holeconference in August 2010, FedChairman Bernanke hinted at QE2,which was implemented in late 2010,ran through mid-2011 and initiated thepurchase of a net additional $600 billion
CHART 4ABX BBB-
Source: Markit
06-1 tranche
Jan-06 Nov-06 Aug-07 Jun-08 Mar-09 Jan-100
10
20
30
40
50
60
70
80
90
100
110
0
10
20
30
40
50
60
70
80
90
100
110
CHART 5Federal Funds Target and Discount Rates
Last Point 9/2/11: fed funds 0-0.25%; discount 0.75%
Like QE1, QE2 did put money in thehands of investors in return forTreasurys, but have no follow-oneffects. As we’ve discussed repeatedlyin past Insights (see June’s report), theFed creates reserves by buying Treasurysand other securities. It doesn’t printmoney, as the media insists, except forpaper currency to satisfy public demand.It requires the cooperation of the banksas lenders and the creditworthyborrowers to turn those reserves intoloans and money. But banks andborrowers have been reluctant to do soand excess reserves over and abovereserve requirements now total about$1.6 trillion (Chart 9). Nonfinancialbusinesses have more than ample cash(Chart 10, opposite page) and little desireto borrow. Creditworthy individualsare also reluctant to borrow, and insteadare paying down their mortgage andother debts (Chart 11, opposite page).
The excess of U.S. corporate liquidity isalso shown by the sluggish growth incommercial and industrial bank loans(Chart 12, opposite page). The M2 moneymultiplier, the ratio of M2 to themonetary base that constitutes bankreserves at the Fed plus currency incirculation, persisted in its decline afterthe earlier nosedive (Chart 13, page 6).Note as well the lack of responsivenessof M2 growth to reserve expansion.Before the financial crisis, M2 wasabout 70 times bank reserves (Chart 14,page 6). When the Fed created $1 inreserves, the banks turned it into $70 ofM2. But since the crisis started in thesummer of 2008, reserves have risen$1,641 billion, but M2 has grown only$1,523 billion. The relationship betweenthe two wasn’t even one to one, muchless 70 to 1!
And don’t think that M2, conventionally-measured money, has been replaced byshadow money such as open marketpaper and money market funds. Asshown in Chart 15(page 6, shadow bank
CHART 7Special Fed Actions 2007
Source: The Wall Street Journal
Expanded open-market operations. Now lends to securities dealers against Treasurysand other high-quality collateral for as long as 28 days.
Lowered the rate on discount-window loans to banks. Now one-quarter of apercentage point over the federal funds rate target, down from a full point.
Created Term Auction Facility. Up to $150 billion in loans auctioned to banksagainst a wide variety of collateral.
Created Term Securities Lending Facility. Swaps up to $200 billion of its ownTreasurys to securities dealers for almost any AAA-rated security.
Opened the discount window to securities dealers.
Lent money to prevent bankruptcy of Bear Stearns.
Extended 'swap' lines to European and Swiss central banks. Lends them up to$62 billion to relend to European banks
CHART 8Case-Shiller 10-City House Price Index
Source: Standard & Poor's
Last Points 6/11: 154.5
Jan-87 Mar-91 May-95 Jul-99 Sep-03 Nov-0760
80
100
120
140
160
180
200
220
240
60
80
100
120
140
160
180
200
220
240
CHART 9Required and Total Reserves of Depository Institutions
With QE2, the Fed did not achieve itsgoal of reducing mortgage rates furtherto aid distressed homeowners (Chart 16,page 7). When Fed Chairman Bernankehinted at QE2 last August, 30-year fixedrate mortgage rates did fall along with10-year Treasury note yields to whichthey are linked, but then rose when theprogram was finally announced inNovember. Was this a classic case ofbuy the rumor, sell the news?
The central bank did, however, succeedin staving off the threat, or at least thefear, of deflation as QE2 fueled thealready rapidly expanding commoditybubble. And it succeeded in stimulatingstock prices (Chart 17, page 7).Apparently, investors reacted as usualto Fed ease by buying equities eventhough the usual and crucial interveningstep—the creation of money throughthe lending of bank reserves to financethose purchases—has been missing. Thesame response no doubt hyped thecommodity bubble (Chart 18, page 7),which also has been fed by expectationsof China and other developing landsbuying all the industrial and agriculturalcommodities in existence. Alsocontributing were bad weather spurringcrop prices and the Middle East unrestspiraling oil prices.
The leaps in stocks and commoditieswere reversed last spring, however.The 2010 sovereign debt crisis in Europewas re-run with increased intensity and,now, the feeling of hopelessness. U.S.consumer confidence has nosedived(Chart 19, page 8) in response toWashington’s handling of the federaldebt limit and fiscal restraint as well aspersistent high unemployment (Chart20, page 8). Notice that Americans trustin banks is almost as low as theirconfidence in Congress (Chart 21, page8). And the prospects of slower globalgrowth if not recession threatens recentrapid growth in corporate profits (Chart22, page 9).
CHART 10Nonfinancial Corporate Cash and Cash Equivalents
Last Point 1Q 2011: 5.62%as a % of total assets
* includes foreign deposits, checkable deposits & currency, time & savings deposits, money marketmutual fund shares, security repos and commercial paper Source: Federal Reserve
1952Q1 1962Q1 1972Q1 1982Q1 1992Q1 2002Q12.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
CHART 11Debt and Debt Service Payments as a % of Disposbale Personal Income
Last Points 1Q 2011: debt 115%; debt service 11.5%
Source: Federal Reserve
1952-I 1964-I 1976-I 1988-I 2000-I30%
40%
50%
60%
70%
80%
90%
100%
110%
120%
130%
140%
10.5%
11.0%
11.5%
12.0%
12.5%
13.0%
13.5%
14.0%
Debt (consumer plus mortgage) / DPI - left axis
Debt Service Payments / DPI - right axis
CHART 12Commercial and Industrial Loans
Source: Federal Reserve
Last Point 8/17/11: all banks 1,286; large banks 665$ billion; seasonally-adjusted
Jan-07 Dec-07 Dec-08 Nov-09 Nov-101100
1200
1300
1400
1500
1600
500
600
700
800
900
1000
All Banks - left axis
Large Domestic Banks - right axis
6 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
Furthermore, we doubt seriously thatthe Fed’s goal with QE2 was to aid justthe folks on top while punishing thelower tier with the higher energy andfood costs that flowed from thecommodity bubble. But that’s whathappened. Until very recently,Americans on the top have benefitedfrom the two-year rally in stocks,commodities, foreign currencies andother investments that were slaughteredduring the Great Recession. The rest ofAmericans are more affected by lingeringhigh unemployment and by falling houseprices that are likely to drop another20%, as discussed in “Still Home Sick”(May 2011 Insight).
As we’ve pointed out in past Insights, the“Median Value of Primary Residence”table (Chart 23, page 9) shows that in2007, the median value of the residencesof those in the bottom 20% by incomewas $103,600 while the top 10% byincome had residences worth $517,800,or five times as much. In 2009, the$450,000 median residence value ofthe top 10% of families by income wasstill five times the $90,000 of the bottom20%.
In contrast, in 2007, the top 10% had$219,000 in stocks held directly andindirectly, or 33.7 times the $6,500median holdings of the lowest 20% offamilies by income, as shown in the“Median Value of Direct and IndirectStock Holdings” in Chart 24 (page 9).So, stock holdings by income groupsare much more skewed toward the topthan residences.
This Federal Reserve Survey ofConsumer Finance from which thesedata are drawn is done every threeyears, but reported quite late. The 2010survey has not yet been released, andthe 2007 survey wasn’t released untilFebruary 2009. The 2009 data for“Median Value of Primary Residence”was an update, but no comparable datahas been released for stock holdings.
CHART 13M2 Money Multiplier
Source: Federal Reserve
Last Point 8/15/11: 3.59M2 money supply / monetary base
CHART 15Shadow Bank vs. Traditional Bank Liabilities
* includes outstanding open market paper, repo liabilities, net securities loaned, total GSE liabilities,total GSE pool securities, total liabilities of ABS issuers, total shares of money market
mutual funds outstanding Source: Federal Reserve
Last Points 1Q 2011: traditional 13.2; shadow 15.8$ trillion
1952Q1 1964Q1 1976Q1 1988Q1 2000Q10
5
10
15
20
25
0
5
10
15
20
25
Traditional Bank Liabilities
Shadow Bank Liabilities*
September 2011 A. Gary Shilling's INSIGHT 7Telephone: 973-467-0070
Despite their lack of effectiveness, QE1and QE2 as well as earlier non-interestrate Fed policy actions were undertakenbecause conventional monetary policy,cutting the federal funds rate, was notdoing the job. And for two distinctreasons. First, as usual, the Fed waspushing on the proverbial string. Pullingthe string, raising rates works becauseborrowers are priced out of the marketby rising interest costs. But loweringrates, pushing on the string, may not beeffective if creditworthy borrowers, asat present, don’t want to borrow andbanks, due to fear and regulations,don’t want to lend. Second, the depthand breadth of the financial crisis, thecollapse in housing, the ongoingsovereign debt crisis in Europe, Japan’scontinuing two-decade-old deflationarydepression, the impending hard landingin China, etc. make the monetary policystring much more limp than usual.
As we discussed in our Oct. 2003 Insight,the question of what the Fed can dowhen the federal funds rate reacheszero was addressed by the now-FedChairman, then-Fed Governor in hiswell-known Nov. 21, 2001 speech. Atthe time, many at the Fed fretted that ifdeflation unfolded, zero, much lessnegative interest rates would beimpossible in real terms. That's beenshown repeatedly by the history ofJapan (Chart 25, page 10). The idea isthat real rates need to be negative formonetary policy to be truly stimulative.In other words, in inflation-adjustedterms, borrowers have to be paid totake the filthy lucre from lenders, as hasoften been the case in U.S. recessions(Chart 26, page 10).
Gov. Bernanke, in his 2001 speech,however, stated that even with a zerofederal funds rate, the Fed was not outof ammunition. I visited him in hisoffice on Jan. 8, 2003 and gave him aframed copy of excerpts from thatspeech, preceded by Winston Churchill’sfamous and defiant words uttered at
the start of World War II (Chart 27, page10). Bernanke thanked me and said hewas delighted to be compared withChurchill, and never had been so before.
Other Options
More recently, other options for morecentral bank ease have been discussedin and out of the Fed. It could reorientits portfolio of Treasurys to longermaturities without enlarging it. The aimwould be to help housing by knockingdown long-term mortgage rates, eventhough that didn’t work with QE2, andto push investors out of low-yieldingTreasury bonds and into riskier assetslike stocks and commodities.
But why wouldn’t investors like us whoown Treasurys for appreciation, notyield, be delighted with the resultingprice rises and stay with them inanticipation of more? And after thejump in stocks and commodities withQE2, but subsequent nosedives, whywould the Fed want to promote anotherpotential rollercoaster ride? Mostimportantly, the commercial banks arethe Fed’s constituents and they arealready hurting from the narrow spreadsbetween near-zero cost deposits andlow lending rates, as we’ll explore later.A flatter yield curve would exacerbatebanks’ woes.
Another widely-discussed option is forthe Fed to pay less than the current0.25% on banks’ reserves that it holds.But that seems unlikely to spur banklending meaningfully and could addfurther to the money market fund stressthat we’ll cover later.
No QE3
Many forecasters expected ChairmanBernanke to announce some sort ofQE3 at last month’s Jackson Holeconference, but were unclear what itwould entail or how it would help.Would adding another $500 billion inexcess reserves to the current $1.6trillion (Chart 9) do any more to induce
CHART 19Measures of Consumer Confidence
Source: University of Michigan and The Conference Board
Last Points 8/11: Michigan 55.7; Conference Board 44.5
lending and borrowing? In any event, atthat August conference, Bernankeproposed no new measures but saidthat the Fed still has “a range of toolsthat could be used.” Back to theNovember 2001 list (Chart 27)?
He also passed the buck on to fiscalpolicy when he said, “Most of theeconomic policies that support robusteconomic growth in the long run areoutside the province of the centralbank.” He then said, “To achieveeconomic and fiscal stability, U.S. fiscalpolicy must be placed on a sustainablepath that ensures that debt relative tonational income is at least stable or,preferably, declining over time.”Bernanke also urged Congress and theAdministration not to kill the falteringrecovery with fiscal restraint, notingthat in today’s extraordinaryenvironment, “policies that promote astronger recovery in the near term mayserve longer-term objectives as well.”
Bernanke seems to be telling investorsnot to count on the “Bernanke put,”the successor to the “Greenspan put,”which meant that the Fed was alwaysthere to bail out risk-prone andsubsequently troubled securitiesmarkets. This is also referred to as themoral hazard problem. Anothervariation of moral hazard is the “toobig to fail” issue in which financialinstitutions take huge risks in the beliefthat they will be rescued by Washingtonsince their failure could take down thewhole financial structure.
The Fed Chairman also may beadmitting that the Fed is out of bailoutbuckets with federal funds now at zeroand quantitative easing anything but araging success. It’s also true that exceptfor bailouts of specific banks, monetarypolicy is very unspecific. Cutting interestrates may or may not encourageborrowing and investing, but it’s up tothe lenders and creditworthy borrowersto decide where any loans get spent.QE2 temporarily helped the upper tierholders of stocks and commodities, but
CHART 22Pre-Tax Corporate Profits
Last Point 2Q 2011: 14.2%year/year % change
* with Inventory Valuation and Capital Consumption AdjustmentsSource: Bureau of Economic Analysis
2007 2008 2009 2010 2011-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
CHART 23Median Value of Primary Residence
Source: Federal Reserve Survey of Consumer Finance
by income class; $ thousand
All Families
Percent of Incomeless than 2020-39.940-59.960-79.980-89.990-100
15.8
63.886.998.5
127.4158.7260.7
131.0
69.285.2
101.2138.5186.4319.5
175.7
76.9109.8148.3192.2247.1494.2
176.0
90.0103.3145.0190.0262.0450.0
207.1
103.6124.3165.7220.0310.7517.8
1998 2001 2004 2007 2009
CHART 24Median Value of Direct and Indirect* Stock Holdings
* indirect holdings include mutual funds, retirement accounts and other marginal assetsSource: Federal Reserve Survey of Consumer Finance
by income class; $ thousand
All Families
Percent of Incomeless than 2020-39.940-59.960-79.980-89.990-100
31.8
6.412.715.324.457.3
171.9
40.4
8.89.1
17.533.575.6
289.7
35.7
8.211.016.528.760.9
225.2
35.0
6.58.8
17.734.162.0
219.0
1998 2001 2004 2007
10 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
hurt the lower tier at which it probablywas aimed by pushing up grocery andgasoline prices, as noted earlier. Incontrast, fiscal policy measures can bequite precise. Helping the unemployedby extending jobless benefits does putmoney in their specific pockets.
Zero-Rate Problems
We’ll turn to the effects of zero interestrates outside the Fed shortly, but firstnote that it creates problems for thecentral bank itself, often with unknownconsequences. Reaching the zerofederal funds rate forced the centralbank into the quantitative easing businesswith unexpected and, on balance, poorresults and meager effects. This andearlier non-interest rate actions alsopushed the Fed uncomfortably close tofiscal policy, which put it in unknownterritory and threatened itsindependence.
This zero federal funds target also ledto the strange negative return on 1-month Treasury bills on August 4 duringthe stampede for liquidity. Investorswere paying the Treasury to lend it theirmoney (Chart 28, opposite page)!Furthermore, a zero federal funds rateleaves the Fed no room to cut it whenthe next recession looms and the centralbank want to provide some offset.
Some observers believe that the recentfirst time ever negative return on the10-year Treasury Inflation-ProtectedSecurities (TIPS) is so strange that itbelongs in Ripley’s Believe It Or Not!(Chart 29, opposite page). Those folksneglect to mention that TIPS returnsare adjusted for inflation. So if inflationover 10 years turns out to be 2%annually, a zero yielding 10-year TIPSwill return 2% per year for that decade.Indeed, the spread in returns betweenTIPS and comparable maturityTreasurys measures market expectationsfor inflation. The current 2% differencefor 10-year securities (Chart 29) suggeststhat investors expect a 2% inflation ratebecause they are indifferent betweenthe TIPS at 0% and the 10-year Treasury
CHART 27“We shall not flag or fail. We shall go on to the end. We shall fight in France, weshall fight in the seas and oceans, we shall fight with growing confidence andgrowing strength in the air, we shall defend our island, whatever the cost may be,we shall fight on the beaches, we shall fight on the landing grounds, we shall fightin the fields and in the streets, we shall fight in the hills; we shall never surrender.”
—Winston Churchill, June 4, 1940“A central bank whose accustomed policy rate has been forced down to zero hasmost definitely not run out of ammunition. The Fed could find other ways ofinjecting money into the system. . . by lowering rates further out along the Treasury term spectrum. . . use its existing authority to operate in the markets for agency debt. . . make . . . loans directly to the private sector . . .offer fixed-term loans to banks at low or zero interest, with a wide range of privateassets (including, among others, corporate bonds, commercial paper, bank loans,and mortgages) deemed eligible as collateral. . . go to the Congress to ask for therequisite power to buy private assets. . . buy foreign government debt.”
—Ben S. Bernanke, Nov. 21, 2002
September 2011 A. Gary Shilling's INSIGHT 11Telephone: 973-467-0070
Many observers believe that low, zeroshort-term rates have forced investorsinto longer-term Treasurys, which haspushed yields down and prices up (Chart30), creating a bond bubble which issure to break. Well, maybe, but we’vebeen hearing similar "bond bubble"arguments since 1981 when 30-yearTreasurys yielded 15.25% and wedeclared that “We’re entering the bondrally of a lifetime.” The rest, as they say,is history.
As discussed in our recent book, TheAge of Deleveraging, except for a handfulof us, virtually all investors hate Treasurybonds. Stockholders realize that whenbond prices are rising, the economy andstocks are vulnerable. Inflation worriersexpect Treasury yields to fall with CPIacceleration, the reverse of the last 30years (Chart 31, page 12). Investmentbanks want yields to rise to encourageclients to do their debt financing rightnow before it gets more expensive.Even professional bond fund managersperennially fret about inflation, higheryields and subsequent losses on theirportfolios. And if yields fall instead,they don’t rejoice over bond appreciationbut wary about reinvesting their interestcoupons at lower yields.
We persist in our conviction that 10-year Treasury coupon yields, whichbriefly fell below 2% in August, willcontinue to drop (Chart 32, page 12).We also continue to forecast a furtherdrop in 30-year yields, now 3.6%, to 3%and perhaps even to the 2.6% reachedat the end of 2008 amidst the Lehmancollapse scare. One well-known bondmanager sold off all his Treasurys earlythis year and then sold them short. Hesaid that owners of government bondswere like frogs slowly being boiled aliveand oblivious to the risks of owningTreasurys. As they say, the rest ishistory. I have a toy frog on my desk,and I've been known to croakoccasionally.
CHART 281-Month Treasury Bill Yield
Source: Thomson Reuters
Last Point 9/2/11: 0.0153%
Jul-11 Aug-11 Sep-11-0.05%
0.00%
0.05%
0.10%
0.15%
0.20%
0.25%
0.30%
-0.05%
0.00%
0.05%
0.10%
0.15%
0.20%
0.25%
0.30%
CHART 2910-Year Treasury and TIPS Yield and Spread
Source: Federal Reserve
Last Points 9/1/11: Treasury 2.15; TIPS 0.07; spread 2.08
Jan-03 Dec-04 Nov-06 Oct-08 Sep-10-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
10 Year Constant Maturity Yield
10 Year TIPS Yield
10 Year Treasury - TIPS Spread (Implied 10 Year Inflation Rate)
CHART 3030-Year Constant Maturity Treasury Bond Price*
* assumes 4.5% coupon paid bi-annually, matures in 30 yearsSource: Federal Reserve and A. Gary Shilling & Co.
As noted earlier, U.S. banks are payingalmost nothing for deposits, whichcontinue to rise in a mad stampede forsafety and liquidity. Since December2007, domestic deposits have leaped$1.1 trillion to $8.1 trillion. Indeed,Bank of New York Mellon last monthbegan charging a fee for corporate cashdeposits of over $50 billion, and othersmay be contemplating similar moves.The reason is that even cheap deposits—which on average pay 0.79%, withchecking accounts close to zero—aren’tprofitable to banks unless they can belent at margins big enough to covercosts.
And that’s increasingly difficult as theyield curve flattens (Chart 33). One-month Treasury rates were essentiallyzero two years ago, as they are now, butin the meanwhile, rates for the longerterm, in which banks normally lend orbuy Treasurys, have fallen considerably.Of course, things aren’t as severe forbank spread lending as in early 2007when the yield curve was inverted withshort rates actually above long rates(Chart 33). The Fed had raised itsfederal funds target in the 2004-2006era before it began slashing it in reactionto the financial crisis (Chart 5).
The squeeze on bank interest ratemargins couldn’t come at a worse timefor banks. With the sluggish economy,total loan demand has been subdued(Chart 34, opposite page). That weaknessis across the board, including commercialand industrial loans to business (Chart12) and consumer credit card borrowing(Chart 35, opposite page). And with anotherrecession in prospect, loan demand isdestined to fall considerably.
Leveraged Up
Starting in the 1970s, banks and otherfinancial institutions leveragedthemselves up dramatically (Chart 36,opposite page) as they moved beyondtraditional bank spread lending to all
CHART 3120-Year Treasury Yield and CPI
Source: Federal Reserve and Bureau of Labor Statistics
sorts of exotic and highly profitableactivities, including special investmentvehicles and other off-balance sheetinvestments, securitization of subprimemortgages, proprietary trading andexotic derivatives. But the financialcrisis to which these activitiescontributed immensely has resulted inrigorous enforcement of previouslyloosely-enforced regulation; new rules,principally the Dodd-Frank law thatproscribed proprietary trading and otheractivities; stockholder pressure toreduce risks; and bank CEO firings andembarrassments for current financialinstitution managements. Banks arebeing pushed back to normally low-profit, and now unprofitable, spreadlending.
Bank yields on assets are in a distinctlydownward trend (Chart 37, page 14),which will no doubt persist as the Fedcontinues to keep short rates at zero fortwo more years and as the likely recessionunfolds (see “Prospects For a 2012Recession,” July 2011 Insight). Nowonder that all of the six largest U.S.bank stocks recently traded at less thantheir net worth.
U.S. banks also have considerableexposure to the sovereign dent troublesin Europe. Of their global total exposure,26% is in the Eurozone and it’s 45% ifthe U.K. is included (Chart 38, page 14).European banks are in worse dangerdue to their heavy ownership of thesovereign debt of troubled Eurozonecountries. And their stocks were dumpedby shareholders last month (Chart 39,page 15). Of course, the Standard &Poor’s downgrade of U.S. Treasurysdidn’t help American and foreign banksthat hold huge quantities of U.S.government securities.
Many U.S. banks still have unresolvedproblems with troubled mortgages thatinvestors who bought them claim weremisrepresented as to quality. Bank ofAmerica is the poster boy in this field,due to its 2008 acquisition ofCountrywide Financial, and its proposed
$8.5 billion settlement with a group ofmortgage bond investors, whichpromised to be the template for otherbank agreements, is opposed by theFDIC, among others. And at the end ofAugust, U.S. Bank sued Bank ofAmerica over a $1.75 billion mortgagebond deal from Countrywide six yearsago in which loans "began to becomedelinquent and default at a startlingrate" soon after the deal wasconsummated.
B of A is also the standout in bankdeleveraging. In order to raise capitalto meet impending global regulatorystandards, the bank just agreed to sellover $8 billion of its China ConstructionBank stock, obviously shrinking its earnings potential. B ofA also recently sold its Canadian consumer credit cardbusiness to TD Bank and is putting its U.K. and Irish creditcard units up for sale. Other noncore businesses that maybe unloaded include mortgage servicing and private equityassets. Revamping the bank’s consumer sectors mayeliminate 10,000 jobs on top of 6,000 already axed this year.
Stockholders Loved Buffett
Stockholders initially greeted with enthusiasm Warren
CHART 37Yield on Bank Assets
Source: Federal Deposit Insurance Corp.
Last Points 1Q 2011: large banks 4.4%; small banks 4.9%
Buffett’s purchase of $5 billion in B of A preferred stockwith warrants for 700 million, or $5 billion, in commonshares, announced August 25 (Chart 40, opposite page). Thiswas the legendary Buffett seal of approval that he gave withbig cash infusions to Goldman Sachs, General Electric andSwiss Reinsurance, among others, in the dark days of 2008-2009 and earlier to Solomon Brothers. Nevertheless, ourinitial and continuing view is that Bank of America’s CEO,Brian Moynihan, accepted Buffett’s proposal out ofdesperation.
September 2011 A. Gary Shilling's INSIGHT 15Telephone: 973-467-0070
The bank’s stock had dropped morethan 40% this year (Chart 40) andalmost 85% from its 2007 peak. Thebank is paying Buffett 6% on thecumulative preferred, less than the 10%Goldman Sachs paid and the 12% forSwiss Re, but at a time when 10-yearTreasurys yield about 2.2% vs. almosttwice as much in 2008 (Chart 29). Andthe cash infusion doesn’t count towardB of A's common equity, which mustabsorb losses, or toward the mostimportant regulatory measure, Tier 1common capital. Furthermore, thewarrants Buffett gets are conservativelyvalued at $3 billion, so the 6% preferreddividend is 15% on his $2 billion netinvestment. In addition, Bank ofAmerica must pay a 5% premium, or$250 million, if it wants to buy back thepreferred.
Treasury Downgrade
The essentially zero federal funds ratemeasures the Fed’s reaction to persistenteconomic weakness and financial woeshere and abroad. These same realitiesresulted in the seemingly diametricreaction in Treasury bonds when S&Pcut its rating on government obligationsafter trading ended on August 5. Thislong-anticipated announcement wasexpected by many (but not us) to resultin a collapse in bond prices as Americansand foreigners abandoned tarnishedTreasurys. After all, S&P was reactingto the nonstop leap in federal deficitsand debt (Chart 41) and Washington’sweak response during the debt limitdebate charades.
Instead, when trading opened onMonday, August 8, Treasuryscontinued the leap that commenced atthe beginning of the month (Chart 30).And that day, 1-month and 3-monthTreasury bills yielded a mere 0.02%(Chart 28 and 6). Why? Thedowngrades enhanced the global rushfor safety and liquidity that had startedin late July in reaction to the Europeansovereign debt crisis and slowing globaleconomic growth with necesaryovertones.
On August 8, the Dow Jones IndustrialAverage fell 5.5%, the biggest dropsince December 2008 (Chart 42).Amazingly, all 30 Dow stocks fell andall 500 stocks in the S&P 500 Indexsuffered losses. Furthermore, corporatebonds and commodities were dumped.Falling confidence in Europe turnedjoy over ECB plans to support Spanishand Italian bonds to dismay over apossible downgrade of France’s triple-A credit rating.
Follow-on downgrades of government-controlled Fannie Mae and FreddieMac as well as five triple-A insurers thattend to have sizable Treasury holdingsalso enhanced the stampede toTreasurys and other safe havens. The$2.9 billion loss for Fannie on homemortgages in the second quarter andposted August 5, up from $1.2 billion ayear earlier, and its request for $2.8billion more in government bailoutmoney didn't help either. Alsodowngraded were 73 bond funds, ETFsand hedge funds with 50% or moredirect and indirect exposures toTreasurys and government agencysecurities. We continue to have big 30-year Treasury bond holdings in portfolioswe manage, but fortunately aren't ratedso we couldn't be downgraded.
Ten of the 12 Federal Home LoanBanks also had their credit ratings cutby S&P as were the ratings on 11,000municipal issuers—to keep them in linewith the lower Treasury rating. Note,however, that that number was lessthan 1% of the 1.2 million issuesoutstanding in the $2.9 trillion munimarket.
General Grant
Shortly after the downgrade, in aBloomberg TV interview, I whimsicallysuggested that if the rating cut was thisbeneficial to 30-year Treasury bonds,my investment favorite for threedecades, I wish S&P would do it again.I went on to relate the story of Gen.Grant in the Civil War who was winningin the West while Union generals in the
CHART 43Net Government and Non-Government Borrowing
East were losing. But Grant had manydetractors who reported to PresidentLincoln that the general drank toomuch. Lincoln asked them to find outwhat brand of whiskey Grant drank sohe could send a barrel to each of hisother generals.
Without doubt, there is a huge globalcrisis of confidence at present. Itessentially results from the realizationthat governments, through theirmonetary and fiscal policies, have nomagic bullets they can fire to return theeconomy to the 1980s-1990s salad daysof rapid growth and soaring stocks.This is The Age of Deleveraging and all thegovernment efforts to date pale inrelation to the deleveraging in the privatesector.
As shown in Chart 43 (opposite page),since early 2006, U.S. federal plus stateand local debt has jumped from around3% of GDP to 9.6% in the first quarter,or about a seven percentage point rise.But during the same time, the privatesector delivered from about 16%borrowing-to-GDP to -0.5%, a 16percentage point drop. So all thegovernment deficits that lay behindthat borrowing and the fiscal stimulusthey represent offset less than half thedeleveraging of the private sector.
Convinced
Earlier, of course, many were convinced that governmentscould save the day. The 2007 collapse in subprimemortgages (Chart 4) touched off the near-meltdown onWall Street, retrenchment by U.S. consumers, global recessionand the related swoon in stocks (Chart 44, opposite page) andcommodities (Chart 45) and the rush to Treasurys (Chart32) and the dollar. In reaction, financial safeguards andbailouts were introduced throughout the developed worldas well as massive monetary (Chart 9) and fiscal stimuli(Chart 46). Convinced that governments had successfullycome to the rescue and that 2008 was simply a bad dreamfrom which they'd awaken, investors in early 2009 reverseddramatically almost everything that had been killed in 2008,including foreign currencies, stocks and commodities whileTreasurys and the dollar retreated.
Those rallies did have some setbacks with the European
CHART 45Reuters/Jefferies Commodity Research Bureau Index
Source: Jefferies & Co.
Last Point 9/2/11: 338
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10100
150
200
250
300
350
400
450
500
100
150
200
250
300
350
400
450
500
CHART 462010-2011 Fiscal Stimulus from
American Recovery and Reinvestment Act of 2009
Source: recovery.gov, Internal Revenue Service, The Wall Street Journal,Department of Labor, Congressional Budget Office and A. Gary Shilling & Co.
$ billion
Category
Aid SpendingHealth Information TechnologyInfrastructure SpendingBuild America Bonds, Tax Cuts, Additional Finance ProvisionsTotal
Cost Est.
$282.1$17.6
$210.7
$303.4$813.7
2010
$134.8$0.0
$62.9
$151.7$349.3
2011 Est.
$78.0$4.4
$61.9
$0.0$144.3
sovereign debt crisis and first Greek bailout in the spring of2010, but then resumed. Their peaks this spring andsubsequent declines reflect the realization by consumers,business and investors worldwide that governments notonly can’t easily return economies and financial markets torobust health, but also that they’ve run out of possibilitiesto try. These worries have been augmented by the realitythat the second Greek bailout is in jeopardy and won’t solvethe basic problems even if successful, and the growingawareness that the Chinese real estate bubble may bust witha hard landing in that country. Political gridlock inWashington is another concern.
Furthermore, the widespread drop in confidence hasfurther dragged down the inherently weak economies bycurtailing investment, consumer spending and employment.So corporations are laden with unspent cash (Chart 10)
18 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
while consumers retrench and pay downdebt (Chart 11).
Negative Effects
A key reason why monetary and fiscalpolicymakers are out of ammo is becauseof the questionable effects of earlierefforts. Quantitative easing by the Fedpiled up $1.6 trillion in excess bankreserves (Chart 9) that lie idle whilepushing up grocery and gasoline pricesfor lower-tier consumers, the verypeople the Fed aimed to help. Fiscalstimuli added over $1 trillion to federaldeficits and debt (Chart 41), spawningsuch a public and political outcry thatfurther massive programs are offWashington’s table.
In Europe, it’s becoming clear that theEurozone either breaks up or movestoward more unity and more bailouts.We’ve believed since the euro wasestablished in 1999 that the basic flawwas combining the Teutonic North withthe Club Med South under a commoncurrency with no central fiscal controlor prospect of it in such diverse lands.The current hope is to create a Eurobondto finance sovereign debts for which theEurozone as a whole will be responsible.
But that would require central controlover national tax and spending policies,a difficult change to sell to profligatecountries like Greece and Portugal. Italso means that the strong countries,led by reluctant Germany, wouldcontinually subsidize the Club Med set.At present, the Eurozone fiscal deficitas a whole is about 4.4% of GDP, notthat bad since it’s held down by theTeutonic North’s fiscal discipline, anddebt-to-GDP is around 87%, far fromthe number for Greece and Ireland(Chart 47).
So the Eurozone as a whole would be astrong borrower. But how much moredebt could be piled on the underlyingbacks of Germany, the Netherlands,Finland and other strong economiesbefore Eurobonds become junk?
CHART 47Eurozone Government Deficits and Debt in 2011
Source: European Commission Forecast - Spring 2011
Furthermore, eurozone economies areslipping toward recession, as discussedin last month's Insight and further showby the nosedives in consumer andbusiness confidence (Chart 48, oppositepage).
Government Deleveraging
The reality is that governments, whichescalated their monetary and fiscalleverage to bail out financial marketsand other private sectors, are now beingforced to join those private economicunits in deleveraging. Attempts to holdback the tide, such as the limits on sellingstocks short in France, Italy, Spain andBelgium, are ineffective attempts toblame market weakness on rumor-mongers and unscrupulous traders. Therecent spike in the Chicago BoardOptions Exchange Volatility Index, orVIX (Chart 49, opposite page), known asthe “fear gauge,” measures theuncertainty and volatility that optionstraders expect down the road.
This is not to say that all the earliermonetary and fiscal stimuli here andabroad was in vain, even though itdidn’t offset the massive private sectordeleveraging and return economies andfinance markets to robust health. Thebasic data shows that from the beginningof the recession in December 2007through July 2011, disposable (after-tax) personal income rose $960 billion,$705 billion from increases ingovernment transfers and tax reductions(Chart 50). From the $960 billion, 31%was saved, much more than the currentaverage saving rate of 5% (Chart 51),but 78% was spent.
The reality is that we’ll never knowwhat would have happened in theabsence of monetary and fiscal stimuli,despite the debate among politicians.As an old history professor of oursused to say, there are no “ifs” in history.It isn’t a controlled experiment whereyou can change the baffles in the mazeand run the rats through again to seewhich way they run.
CHART 50Federal Government Stimuli for Consumers
cumulative changes Dec. 2007 to July 2011; $ billion
Government TransfersPersonal Taxes
Personal incomeDisposable Personal Income
SavingPersonal ConsumptionCurrent Transfer and Interest Payments
585.2-119.6
840.1959.7
299.5747.6-87.4
Total Stimuli704.8
Shares ofDPI Change
31.2%77.9%-9.1%
CHART 51U.S. Personal Saving Rate
Source: Bureau of Economic Analysis
Last Point 7/11: 5.0%seasonally-adjusted annual rate
With the global crisis of confidence hascome a universal lust for liquidity,especially cash. In the week endingAugust 1, the M2 money supply, whichincludes currency in circulation, bankdeposits and retail money market funds,leaped $159 billion, or 1.7%, the thirdbiggest jump since 1980. In perspective,the biggest was 3.2% right after 9/11and the second, the 2.3% gain in theweek of September 2, 2008 whenLehman collapsed (Chart 52, page 19).
As implied earlier, normal growth inM2 is linked to borrowing used tospend or invest, but spikes, as recently,are related to financial panics. And, according to a 1983study by then-Prof. Ben Bernanke, the flight to cash and theimplied risk aversion was a key reason for the 1929 Crashand ensuing Depression. Both U.S. individuals andcorporation are raising cash, often by issuing debt to do so(Chart 10). Banks are also involved, as measured by that$1.6 trillion in excess bank reserves packed safe and soundat the Fed (Chart 9).
In Europe, bank deposits at the ECB hit a 2011 high of€145 billion in early August even though that central bankpays a lower interest rate than interbank markets. Andmany banks probably will need the money later. The July“stress tests” were widely viewed as too easy to pass, asreinforced by an unusual move recently by the InternationalAccounting Standards Board. It said that some Europeanbanks are using their own models to value Greek debtrather than the required market prices to determine thesecurities’ fair value. The “mark to model” rather than“mark to market” approach vastly overvalues the troubledGreek government debt they hold that has collapsed invalue. Yields on 2-year Greek government debt hit arecord of 43% in late August. Similarly, drops in the valueof Spanish and Italian government bonds have impairedthe balance sheets of their banks which hold large quantitiesof those sovereigns.
In July, the Committee on the Global Economic System, acentral bank oversight group, said that an increase in“sovereign risk adversely affects banks’ funding coststhrough several channels, due to the pervasive role ofgovernment debt in the financial system.” The decliningvalue of government debt, the panel went on, could weakenbank balance sheets and make bank funding more difficult.Indeed, European banks have been scrounging for U.S.dollars to add to their already-large liquidity hordes as U.S.
money markets and other traditional sources becamereluctant to lend to them.
Stressed Greek Banks
Meanwhile, Greek banks are stressed by massive withdrawalof deposits that move to safe-deposit boxes and undermattresses. One unlucky saver stashed cash in a brick wallbut rats ate it. Deposits in Greek banks by households andbusinesses peaked at €238 billion in September 2009, butplummeted to €188 billion this June. About half of thesewithdrawals have fled the country, the central bank estimates,as chronic tax evaders fear a crackdown.
The Greek bank withdrawals have led to a bank liquidityshortage and increased reliance in the ECB for funding, andalso to bank lending cuts and a further deepening in theGreek recession. The government now estimates a 5%drop in GDP this year compared to the 3.8% declineforecast on July 1.
Furthermore, Greek banks have heavy exposure to Greekgovernment bonds, now rated junk, so they're frozen outof the interbank lending market. Piraeus Bank recentlyannounced a €1 billion writedown of its bond holdings. It'salso borrowing from a special central bank fund used tocover cash needs, the second Greek bank to do so, since itscollateral is too weak to back ECB loans. The Piraeuswritedown was part of the second Greek bailout dealreached in July.
The ongoing banking crisis no doubt was key to the recentdecision of EFG Eurobank Ergasias and Alpha Bank,Greece’s second and third largest banks, respectively, tomerge into the nation’s largest. This strikes us as twodrunks leaning on each other in an attempt to keep each
September 2011 A. Gary Shilling's INSIGHT 21Telephone: 973-467-0070
Another result of the zero interest rateworld was the earlier investor rush tojunk securities in their zeal for higheryields. That drove the spread betweenjunk bonds and Treasurys from its 20percentage point peak in December2008 almost back to the previous lowin June 2007, according to our friend,Prof. Ed Altman of NYU (Chart 53,opposite page). In 2009, junk bonds’appreciation and interest returnscombined were 57.3% and a further15.3% in 2010. As in earlier boomtimes, investor zeal made refinancingsub-investment-grade securities easy,so defaults in the first half of 2011, at0.2%, were also near record lows (Chart54). Refinancing money was so readilyavailable that defaulting on junk securitiestook real skill.
But the August agonizing reappraisal offinancial markets has hit junk hard.Retail investors, who poured $2.8 billioninto junk mutual funds in July and $43.8billion between March 2009 andFebruary 2011, yanked out $4.6 billionin the first three weeks of August. Thatforced junk mutual funds to sellsecurities, resulting in a -5.1% totalreturn in the same weeks.
The junk yield spread over Treasurys,using Barclays Capital High Yield Index, leaped to 7.66percentage points last month—the highest since November2009—from 5.87 points at the end of July. This spreadlevel, in the past, is associated with recessions when slowgrowth and lack of junk security financing hypes defaultrates (Chart 54).
With this rapid reversal, it’s not surprising that the junkissuers raised only $1.2 billion in August, down 93% fromJuly’s $18.2 billion and the lowest since the market dried upin December 2008.
REITs also benefited from investor zeal for yield in a lowinterest rate world. Also, investors earlier saw them asimmune from Europe's debt crisis and benefiting from theexpected revival in economic growth and employment andthe resulting demand pick-up for commercial real estate. Inthe first half of 2011, the Dow Jones Equity All REIT Index
was up 9.9% vs. 6% for the S&P 500. In the last two years,REITS returned about 30% annually.
As Insight readers know, however, we've been cautious onREITs except for those involved with rental apartmentsand medical office buildings, and felt their stocks got waytoo far ahead of themselves. Recently, they've fallen backalong with stocks in general. Also, lending for commercialreal estate-backed securities is drying up, curtailing REITacquisitions and debt refinancing. And the looming recessionwill cut demand for office space, hotel rooms and warehouses.
Are Stocks Cheap?
Low and zero interest rates also influence investors’ viewsof the values of stocks. The theory says that lower interest
(continued on page 24)
CHART 54High-Yield Bond Default Rates
Source: Ed Altman / NYU Salomon Center
Last Points 3Q 2011 through 8/26/11: qtrly 0.13%; moving avg. 0.78%
1989 1992 1995 1998 2001 2004 2007 20100.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
0%
2%
4%
6%
8%
10%
12%
14%
16%
Quarterly Default Rate - left axis
12 Month Moving Average - right axis
CHART 55Price-to-Earnings Ratio
Source: Robert Shiller and Haver Analytics
Last Points 7/11: cyclical adj. ratio 22.9; P/E ratio 14.7cyclically-adjusted and standard
1960 1968 1976 1985 1993 2001 20100
20
40
60
80
100
120
140
0
20
40
60
80
100
120
140
Cyclically Adjusted PE Ratio
PE Ratio
PE Average = 19.0
Cyc. Adj. Avg. = 19.4
22 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
INVESTMENT THEMESOur Investment Themes section reflects the positions that are in or being considered for our managed portfolios.We may add or delete portfolio positions in the course of the month, but those changes will not be shown in Insightuntil the following month’s report.
Treasury bonds (favorable) Treasurys are rallying as asafe haven in a sea of trouble and in response to slowingeconomic growth and looming global recession. Thelikelihood that inflation fears will turn soon to deflationworries will also propel them. These are available throughsecurity brokers, banks and www.treasurydirect.gov as wellas via ETFs and futures contracts.
Income-producing stocks (favorable) Included areutilities, drugs and telecoms with high, safe and risingdividends, but hedge them against further stock marketweakness. They can be purchased individually or via ETFs.
The dollar vs. the euro and Australian dollar. Also theDollar Index (favorable) The eurozone remains in deeptrouble and the buck is the world's safe haven. The euroappears finally to be breaking. Australia has become aChinese colony as the island continent's minerals are dug upand sent to China. And China is in the "stop" phase of herstop-go economic policy. Almost everyone has dumped thedollar, and it may be ready for a substantial rally. Implementthis theme with futures contracts and ETFs on the dollarindex as well as put options.
Eurodollar futures (favorable) This theme depends onthe Fed continuing to keep rates flat in the face of anuncertain economy. Big moves in eurodollar prices aresmall in absolute terms, so an investor needs the leverage offutures contracts to make meaningful money. The Fedannouncement of no federal fund rate change for two years,however, means that most of the potential of this theme isexploited. Calls on the futures are also available.
Rental apartments (favorable) are gaining favor by thosewho can't afford home ownership and are discouraged byfalling house prices. REIT prices seem overblown, butdirect ownership of rental apartments may still be attractive.
Medical Office Buildings (favorable). The aging postwarbabies, the 2010 health care law and the migration ofphysicians from private practice to hospital employmentwill promote robust, steady growth in this real estate sector.But government regulations can be disruptive. Implement
with REITs and direct ownership.
North American energy (favorable) As a nation, the U.S.has decided to reduce dependence on imported energyfrom high-risk areas such as Venezuela, Africa, Russia and,especially, the Middle East. We like conventional energyinvestments including natural gas, on- and off-shore drillingand Canadian oil sands. New nuclear facilities may bepostponed in the wake of the earthquake and tsunami inJapan. Renewable energy, including ethanol, is problematicsince it depends heavily on unpredictable governmentsubsidies. Implement with futures, ETFs and individualstocks. Consider the recent bankruptcies of two U.S. solarpanel producers.
Sell your house, second home or investment single-family houses yesterday, if you plan to do so any timesoon (unfavorable) Excess inventories are likely to pushprices down another 20% over the next several years.
Sell homebuilders in view of the deteriorating housingoutlook. Implement with ETFs.
Developing country stocks (unfavorable) China is likelyto have a hard landing. Implement with ETFs on China-related stocks.
Commodities (unfavorable) The commodity bubble isbeginning to break as others join us in thinking about a hardlanding in China, falling U.S. house prices, troubles in Japanand the eurozone and slowing growth globally Oil may bethe exception with Middle East uncertainty. Implementwith stocks, ETFs and futures. Short copper if you agreeon global production slowdown.
Sell U.S. major and regional banks. Major bankswrestle with regulators over bad mortgages, and the prospectof another 20% fall in house prices means more woes.Regional banks suffer from weak loan demand and bad realestate loans, and will be negatively affected by slowereconomic growth if not another recession. Implement thisstrategy with ETFs.
Eurozone business and consumer confidence are both nosediving as Greek bailout #2 flounders. The U.S. economy is closeto a recession with August payroll employment flat from July, which was revised down as was June. The Chinese authoritiesare determined to curb the real estate bubble and inflation, and we continue to forecast a hard landing there. This atmospherefits our investment strategies like a glove: long Treasury bonds, short stocks, short commodities and long the dollar.
September 2011 A. Gary Shilling's INSIGHT 23Telephone: 973-467-0070
Dow Jones IndustrialsS&P 500Nasdaq CompositeNikkei AverageFTSE 100Hang Seng
*through Aug. 31
The phrase “dog days of August” seemed to be particularlyapplicable last month—to the economy, to stocks and tothe national mood. After all, there was little to cheer amidstthe near-default of the U.S. government and then thedowngrade of the nation’s credit to start the monthfollowed by the East Coast earthquake and hurricane laterin the month. Add in continued fears over the viability ofthe economic recovery and, by the end of August, thedamage to stocks was significant, although thanks to a fewrallies amidst the carnage, it could have been much worse.In the end, the Dow Jones Industrials fell 4.4% while theS&P 500 index was off 3% and the Nasdaq ended Augustoff 2.8%. Overseas bourses fell even more sharply. Onenote of caution, though, in the wake of the lousy Augustperformance: September is historically the worst month forstocks.
Seeking safety amidst the August volatility, investors droveyields on 10-year Treasurys to their lowest levels (evenslipping briefly below the 2% mark) since late 2008. Thedollar, meanwhile, held fairly steady throughout the Augusttumult against the euro and the yen.
Fed Chairman Bernanke threw cold water—for now—onany new round of Treasury bond-buying by the Fed, insteadsaying in an Aug. 26 speech that “most of the economicpolicies that support robust economic growth in the longrun are outside the province of the central bank.” He alsopronounced himself optimistic about long-term prospectsfor the U.S. economy: “The growth fundamentals of theUnited States do not appear to have been permanentlyaltered by the shocks of the past four years.”
The era of maintaining low interest rates for “an extendedperiod” is over. After its Aug. 9 policy meeting, the Fed saidthat “economic conditions—including low rates of resourceutilization and a subdued outlook for inflation over themedium run—are likely to warrant exceptionally low levelsfor the federal funds rate at leastthrough mid 2013.” And minutesfrom that meeting reveal somedivisions among policymakers overthe best course for fixing theeconomy, with one groupadvocating aggressive actions andanother backing a more hands-offapproach.
Consumer prices in July rose 0.5%after falling 0.2% in June. Year-over-year CPI is 3.6%. Core CPIwas up 0.2% in July, with the 12-month core rate up 1.8%. Producer
August 2011% Change*
Year-to-Date% Change
-4.4% -5.7%-6.4%-8.9%-7.2%-8.5%
+0.3% -3.0% -2.8%
-12.4%-8.6%
-10.6%
10-yr. Treasury note$=¥$=€
July 29Aug. 312.21%76.610.69
2.81%76.970.69
prices, meanwhile, rose 0.2% in July and are up 7.2% year-over-year. Core PPI advanced by 0.4%, with the 12-monthrate up 2.5%. The core personal consumption deflator,closely watched by the Fed, was up 0.2% in July and is ahead1.6% year-over-year. Crude oil prices fell from the mid-$90 per barrel range at the start of the tumultuous monthto their lowest levels in a year before reviving a bit to endAugust down about eight percent for the month. Gasolineprices, however, were not similarly inclined to fall.
Due to fewer exports and weaker growth in inventories,second quarter GDP growth was revised down to 1% vs.the 1.3% first reported in late July. GDP in the first halfof this year was up only 0.7%.
Retail sales in July were up 0.5% vs. June, whose gains wasupwardly revised to 0.3%. Gasoline sales were up 1.6%,electronics and appliance store sales rose 1.4% and autosales advanced 0.4%. Ex autos, retail sales were ahead0.5%. Meanwhile, the national credit card delinquency ratefell to 0.60% in the second quarter, the lowest rate in 17years, according to TransUnion.
Nonfarm payrolls were flat—zero growth—in Augustwhile the advances for June and July were revised downward.The national unemployment rate slipped from 9.2% to9.1% in July and remained at that level in August.
After rising nearly 15% in June, housing starts fell 1.5% inJuly, with single-family homes falling 5% and apartmentbuildings rising 6%. Building permit issuance was down3.2%. New home sales fell 0.7% in July from June andJune’s drop was revised downward. Sales have fallen 18%in the past two years. Existing home sales fell 3.5% in Julyfrom June—the third decline in four months.
The Case-Shiller 20-city home price index fell 4.5% in Junefrom a year earlier on the heels of a 4.6% drop in the 12months ending in May. The National Association of HomeBuilders’ confidence index remained at 15 in August, well
below the 50 mark separatingpessimism from optimism.
Consumer sentiment fell to 55.7 inAugust from 63.7 in July, theUniversity of Michigan reported.The Conference Board’s index ofconsumer confidence fell to 44.5in August—its lowest reading inmore than two years—from 59.2in July.
Fred T. RossiEditor
24 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
reduces the discounting rate thatconverts future earnings into currentstock values and thereby raises theirpresent worth. Also, lower interestrates are supposed to raise price-earningsratios by making stocks cheaper relativeto bonds.
In any event, stock bulls and manyequity analysts believe that corporateprofits growth (Chart 22) has been sorobust that even considerable economicweakness will not depress stock pricessignificantly from current levels. And,as usual, equity analysts see robustcompany-by-company earnings for2012, with a gain of 14.4% for thisyear’s estimate for S&P 500 operatingearnings. More sober, top-downstrategists still look for a rise of 5.9%.Those numbers put the S&P 500currently selling at 10.3 and 11.4 timesnext year’s earnings, respectively—reasonably cheap relative to the 19.0average P/E since 1960.
But only two quarters of 2011 earningsare recorded so far, and estimates forthe second half may prove to be far toorosy, jeopardizing the bottom-upanalysts’ forecast of a 17.8% gain for2011 and 14.8% for the top-downstrategists. Similarly, their forecasts for2012 may prove unrealisticallyoptimistic.
We’ve never understood the conceptof P/Es that compare current priceswith next year’s earnings forecast. Itstrikes us somehow as double-discounting, of forecasting futureearnings and then treating thoseforecasts as certain enough to determinethe current values of stocks. Thisapproach works in long bull marketswith steady earnings gains, but come acropper when the bear visits.
Our friend, Yale Professor RobertShiller, avoids this problem as well asthe volatility of recent corporate earnings
CHART 56Japanese Urban Land Prices
Source: Japan Real Estate Research Institute
Last Point 1Q 2011: 68.8six-city average; 2000 Q1=100
by calculating the S&P 500 P/E basedon earnings over the last 10 years (Chart55, page 21). His average since 1960 is19.4, implying that stocks in July whenhis P/E was 22.9 were 18% overvalued.More important, in reaching that long-term average P/E of 19.4, stocks spendabout half the time above it and halfbelow. Most of the last decade hasbeen above the average line, so theremay be some catching up on the downside. This fits our view of a decade orso of deleveraging and a secular bearmarket that started in 2000, as discussedat length in our July 2011 Insight and inThe Age of Deleveraging.
The U.S. and Japan
Interest rates close to zero and all the related issues arerelatively new in the U.S. and Europe, but they’ve beenaround in Japan for two decades (Chart 25). So, manywonder if the U.S. is headed for Japan’s 20-years-and-running deflationary depression. And regardless, what doesthe Japanese experience tell us about living in thisatmosphere?
The Japanese bubble economy was cruisin’ for a bruisin’,and its demise was aided by the Bank of Japan’s hike ininterest rates, starting on May 31, 1989 (Chart 25). Soon,exuberant real estate prices collapsed (Chart 56, oppositepage) as did stock prices (Chart 57, opposite page), andeconomic growth nearly ceased (Chart 58, opposite page).See The Age of Deleveraging and past Insights, most recently “AFaster Train Wreck” (April 2011) for more details. Lately,the earthquake and tsunami have added to Japan’s woes, atleast on a short-term basis. Real GDP fell 1.3% in thesecond quarter from a quarter earlier atannual rates, following the 3.6% dropin the first quarter and the third quarterin succession to decline (Chart 59).
Similarities
There are a number of similarities thatsuggest that America is entering acomparable long period of economicmalaise. The Age of Deleveraging forecastsa similar decade, at least quite a fewyears, of slow growth and deflation asfinancial leverage and other excesses ofpast decades are worked off. Therecent downgrade of Treasurys by S&Pparallels the first cut in Japanesegovernment bond ratings in 1998,
CHART 59Japanese Real GDP
Source: Japanese Cabinet Office
Last Point 2Q 2011: -1.3%quarter/quarter % change; seasonally-adjusted annual rate
2007 2008 2009 2010 2011-20%
-15%
-10%
-5%
0%
5%
10%
-20%
-15%
-10%
-5%
0%
5%
10%
CHART 60Japanese and U.S. Central Government Budget Balances
Source: Office of Management and Budget and Japanese Ministry of Finance
Last Points 2010: U.S. -8.9%; Japan -9.3%as a % of GDP
1980 1985 1990 1995 2000 2005 2010-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
Japan
USA
followed by S&P’s cut to AA-minus early this year andMoody’s reduction from Aa2 to Aa3 last month.
The recent slow growth in the U.S. economy—real GDPgains of 0.4% in the first quarter and 1.0% in the second—looks absolutely Japanese. Furthermore, the prospects ofsubstantial fiscal restraint in the U.S. to curb the federaldeficit is reminiscent of tightening actions in Japan in themid-1990s. The economy was growing modestly, butdeficit- and debt –wary policymakers in 1997 cut governmentspending and raised the national sales tax to 5%. Instantrecession was the result.
Big government deficits in recent years are another similarlybetween these two countries (Chart 60) and the U.S. netfederal debt-to-GDP ratio is headed for the Japanese level(Chart 61, page 26). Japan’s gross government debt last yearwas 226% of GDP, far and away the largest ration of anyG-7 country. All governments lend back and forth among
26 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
official entities so their gross debt isbigger than the net debt held by non-government investors, and Japan doesmore of this than other developedlands. Still, on a net basis, hergovernment debt-to-GDP is only rivaledby Italy’s and leaped from a mere11.7% in 1991 to 120.7% in 2010. Isthe U.S far behind (Chart 62)?
Japan, in reaction to chronic economicweakness, has spent gobs of money inrecent years, much of it politically-motivated but economicallyquestionable, like paving river beds inrural areas and building bridges tonowhere. Is that distinctly differentthan the U.S. 2009 $814 billion stimuluspackage (Chart 46) that was supposedto finance shovel-ready infrastructureprojects when, in reality, the shovelshad not even been made yet?
A key reason for the 2009 and 2010U.S. fiscal stimuli and continuing deficitspending in Japan is because aggressiveconventional monetary ease (Charts25and 5) did not revive either economy.Zero interest doesn’t help when banksdon’t want to lend and creditworthyborrowers don’t want to borrow. Bothcentral banks found themselves in classicliquidity traps, so both resorted toquantitative ease, without notablesuccess.
But Differences, Too
There are, then, many similaritiesbetween financial and economicconditions in the U.S. and Japan.Nevertheless, there are considerabledifferences that make her experience inthe last two decades questionable as amodel for America in future years.Note, however, that every time I visitJapan, I return convinced that Iunderstand less about how they functionthan I did on the previous trip. I’m surethey behave rationally, but it’s a differentrationale than in the West, or at least theone I understand.
The Japanese are stoic by nature, alwayslooking for the worst outcome while
CHART 62U.S. and Japanese Net Debt
Source: International Monetary Fund
Last Points 2010: Japan 117.5%; U.S. 64.8%as a % of GDP
1980 1985 1990 1995 2000 2005 20100%
20%
40%
60%
80%
100%
120%
0%
20%
40%
60%
80%
100%
120%
Japan
U.S.
CHART 632010 G-7 and BRIC GDP, Population and GDP per Capita
* IMF estimates Source: Organization for Economic Cooperation and Developmentand International Monetary Fund
Americans are optimistic—not asoptimistic as Brazilians, but still proneto look on the bright side. Otherwise,why would the Japanese voters standfor two decades of almost no economicgrowth? Japanese are comfortable withgroup decision-making while Americansrevere individual initiative, somethingthe Japanese disdain. The nail thatsticks up will be pounded down, is afavorite expression there. Perhapsbecause of this, the governmentbureaucracy in Japan is much strongerthan in the U.S. while elected officialshave less control and room for initiative.
Despite little economic growth, Japaneseenjoy high living standards (Chart 63,opposite page). And the Japanese are anextremely homogenous and racially-purepopulation, except for around 25,000natives called Ainu who are left overfrom the Japanese invasion from Koreasome 4,000 years ago. In a related vein,immigration visas don't exist in Japan,so there’s nothing in Japan like thechronic shift of U.S. income to the topquintile (Chart 64). Nothing like thetwo-tier economic recovery thatbenefited top-tier stockholders in 2009-2010, but left the rest struggling withcollapsing prices for their homes (Chart8) and high unemployment (Chart 20).
Fertility rates in Japan are about thelowest in the world (Chart 65) and lifeexpectancy is high (Chart 66). So therapidly aging (Chart 67, page 28) anddeclining population (Chart 68, page 28)lack the innovation and dynamism ofmore youthful populations in the U.S.where immigration, legal and illegal, ishigh as are fertility rates.
Export-Led
Japan in the post-World War II era hasbeen an export-led economy (Chart 69,page 28). “Export or die,” is thewatchword. The result of robust exportsand weak imports linked to anemicdomestic spending is her perennialcurrent account surpluses (Chart 70,page 29), which, along with earlier highsaving by households and now bybusinesses, allow her to finance her
huge government deficits internally, withforeigners owning only 5% (Chart 71,opposite page). As a result, her governmentbond yields are extremely low (Chart72, opposite page).
In contrast, the U.S. is a chronicimporter with a chronic current accountdeficit (Chart 70). So foreigners haveperennially bought Treasurys with theresulting dollars they earn, and theynow own about 50% of them. AndTreasury note and bond yields are muchmore controlled by global forces andhigher as well than in Japan (Chart 72).The U.S. is largely an open economybut Japan’s, except for her formidableexport sector, is largely closed to theoutside world.
Another big difference is the chronicstrength in the yen and long-timeweakness in the dollar (Chart 73, page30), resulting in part from the differencebetween Japan’s chronic current accountsurplus and America’s chronic deficit(Chart 70). Even near-zero short-termrates (Chart 25) and 10-year governmentbond yield of about 1% (Chart 72) donot deter those who lust for the yen. Ofcourse, in a zero interest rate worldwhere interest returns have droppedclose to traditionally low Japanese levelsin the U.S. and elsewhere, Japan atpresent does not have much of acompetitive disadvantage.
The yen’s strength has led to Japanesemanufacturers moving much of theirproduction to lower-cost areas, butdeflation in Japan has offset some ofthe difference. Corrected for deflationand on a trade-weighted basis, includingtrading partners such as Switzerlandwith robust currencies, the yen has beenrelatively flat since the 1980s, accordingto a Bank of Japan analysis (Chart 74,page 30).
Nevertheless, the government hasintervened in currency marketsnumerous times, most recently spending$13 billion in early August, to arrest theyen’s climb vs. the greenback. And, ofcourse, a government intervening
CHART 67Percentage of Population Over 65
Source: Japanese Government White Book of Aging
1960 1980 1995 2000 2005 2025 20505%
10%
15%
20%
25%
30%
35%
40%
5%
10%
15%
20%
25%
30%
35%
40%
Japan
USA
UK
CHART 68Japanese Population
Source: Japanese Statistics Bureau
Last Point 2010: -0.1%year/year % change
1955 1965 1975 1985 1995 2005-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
CHART 69Japanese Real GDP and Exports
Source: Japanese Cabinet Office
Last Points 2Q 2011: GDP -0.9%; exports 5.1%year/year % change
against its own currency can’t run outof ammunition since it can easily createmore of its own currency to sell on theopen market. Still, intervention successhas been limited, short-lived andexpensive. Even a determinedgovernment with unlimited ammo hasnot been able to overcome the giganticglobal currency markets that tradetrillions of dollars daily.
Deflation
Japan, of course, is mired in deflation,and while we continue to believeAmerica is headed there as well, theU.S. CPI is still rising (Chart 75, page 30).In fact, many in and out of the Fedbelieve serious U.S. inflation is in thewings. As shown earlier, the spreadbetween 10-year Treasurys and TIPSimplies an annual CPI rise of about 2%over the next decade. A similar measurein Japan reveals expectations ofcontinuing deflation over the next 10years.
What’s Left To Be Done?
We conclude that the differencesbetween the U.S. and Japan are toogreat to use the Japanese economicexperience in the last two decades as atemplate for the U.S. in coming years.Still, as discussed in The Age of Deleveraging,we expect a similar lengthy period ofslow growth and deflation as theeconomy delevers. In any event, canpolicymakers do much to forestall thisoutlook? We argue in The Age ofDeleveraging and did so earlier in thisreport that they can’t any more than theJapanese have been able to generaterobust economic growth.
A decade ago, the Fed was worriedabout deflation infecting the U.S. andassigned a dozen of its top economiststo study Japan to see how chronicfalling prices could be avoided. Theirconclusion: Institute massive monetaryease early before deflation becomes awell-established and anticipatedphenomenon.
CHART 71Japanese Government Bondholders
Source: Bank of Japan
March 2011
CHART 70U.S. and Japanese Current Account
Source: Bureau of Economic Analysis and Japanese Ministry of Finance
Last Points: Japan 2Q 2011 4.0%; U.S. 1Q 2011 -0.8%as a % of GDP
Now-Fed Chairman Bernanke in earlieryears also believed the BOJ activitieswere too little, too late, and that then theJapanese central bank pulled back whenthe economy seemed to be reviving.It’s holdings of government bondsjumped from ¥45.7 trillion in 2001 to¥67.2 trillion in2004, but aren’t muchhigher today at ¥86.0 trillion. TheBOJ’s securities-buying program earlierthis year of ¥5 trillion, or around $65billion, is only about 10% of the Fed’s$600 billion QE2 program. Note,however, that the Fed’s much largerquantitative easing hasn’t been a greatsuccess either, as discussed earlier.
Furthermore, the U.S. central bank’sfear of a self-feeding deflationary spiralhas not occurred in Japan. That takesplace when lower prices encouragepotential buyers to wait for still-lowerprices, which are then induced bymounting inventories and excesscapacity. So those buyers wait evenfurther, etc., in a self-feeding downwardprice spiral. In Japan, deflation hasbeen an on-and-off phenomenon for20 years with no cumulative downwardspiral in prices (Chart 76, opposite page).This graph also reveals that M2 moneysupply growth of about 3% annually inthe last two decades has not preventedperiodic price declines. Again, Japanhas been and the U.S. now is in a classicliquidity trap.
Switzerland
Switzerland, another strong currencycountry (Chart 77, opposite page), alsoworries about the robust franc’snegative effects on its manufacturing,drug, tourism and other nonfinancialbusinesses. The government earlierproposed $2.4 billion in aid forunemployment insurance and tourism,but recently cut the amount by morethan half as a first installment. Swissstocks have joined other markets infalling lately (Chart 78, opposite page).
In the past year, the franc leaped 11%against the euro and 22% vs. the dollar
CHART 74Real and Nominal Yen Effective Exchange Rate
Source: Bank of Japan
Last Points 7/11: real 101.5; nominal 122.1index value
(Chart 77). As with the yen, wheninterest rates are close to zero, it’scheap for speculators to bet oncurrencies with low costs, huge leverageand prospectively gigantic profits.Switzerland also attracts global moneyseeking a safe haven with her traditionalstability, neutrality, gross public debt of52% of GDP, unemployment rate of3% and government surplus last year.With the rush of money into Switzerlandand low investment returns on it, giantSwiss bank UBS is considering atemporary charge on deposits to limitinflows.
The Swiss National Bank has also movedto curtail inflows by cutting interestrates close to zero in early August andflooding the market with money, whichsent short-term interest rates negative.As a result, the franc has fallen recently(Chart 77). Interventions in currencymarkets by the SNB in 2009 and 2010loaded it with enormous losses as theeuros and dollars it bought continued tofall. It lost an additional $15 billion inthe first half of 2011.
An interesting fallout from the leapingfranc has been huge mortgage costincreases for homeowners in Hungary,Poland and Croatia. They borrowed infrancs in the mid-2000s because Swissinterest rates were low, but now arestuck with much bigger mortgages intheir own currency terms because oftheir currencies' drop against the franc.They’ve learned the hard way that there’sno such thing as free lunch. Swissfranc-denominated debt, mostly homemortgage loans, equals 15% to 20% ofHungarian GDP and about 10% inPoland and Croatia. The Polish andHungarian governments have beenforced to bail out these haplesshomeowners.
Gold
Some compare the Swiss franc to gold,and both have served as safe havens oflate. And both have seen a lot ofstrength recently (Chart 79, page 32).We’ve always been agnostic on gold
CHART 76Japanese Money Supply and Prices
Source: Bank of Japan and Statistics Bureau of Japan
Last Points 7/11: CPI 0.2%; M2 2.9%year/year % change
since its price is influenced by so manyforces that it’s hard to figure out howthey play out on balance. Think aboutpolitical risk, economic uncertainty,inflation and deflation, central bankholdings, Indians who buy gold in goodtimes and trade down to silver in bad,new gold-mining techniques, the goldbugs who hold a gold bar in one handand an AK-47 and dried food in theother, etc.
In the inflationary 1970s, gold leaped toover $800 per ounce as an inflationhedge, but them went nowhere untilrecently, apparently as the various forcescancelled each other. The current jumpseems to be a safe haven play as well asreflect a distrust for paper currencies ingeneral. There’s been little inflation oflate, and the dollar has been trendingsideways so those factors aren'tresponsible. Gold is also probably beingpropelled by low interest rates, whichslash its carrying costs, and the uncertainatmosphere that surrounds zero or evennegative rates.
But gold returns nothing, and even atzero interest rates still costs money tosecure and store. And gold prices can bevolatile, as shown by the $104.20 perounce drop in price—5.6%—in oneday, August 24, as the selloff triggeredmargin calls and more selling. And itdropped $143.50 per ounce in January1980 after peaking at $825.50, or$2,397.15 when adjusted for subsequentinflation. Recently, gold has shown theclassic signs of speculation in whichpeople buy it solely because they thinkit’s going up.
Brazil
Zero interest rates in the U.S. and otherdeveloped countries have distorted theBrazilian economy. Just look no furtherthan the leap real currency (Chart 80)and falling Brazilian stock market (Chart81). The global commodity bubble,propelled in part by low interest costs forspeculators, has benefited Brazil, theworld’s biggest exporter of iron ore,beef, chicken and sugar, and the economy
leaped 7.5% last year. Nevertheless,with the Bovespa stock index down18% this year and among the world’sweakest, many Brazilian corporationsplan to buy back shares even thoughthat could drain cash needed forexpansion and to cope with volatiletimes.
Foreign money has poured into Brazildue to zero returns elsewhere and the12.0% central bank rate, just cut from12.5% to relieve some of the upwardpressure on the real. But the strong realhas been detrimental to exporters as hasaccelerated inflation, now 7% year-over-year. Inflexible labor markets and poorinfrastructure are also problems. Lessthan 12% of Brazil’s one million milesof road are paved and the rail network issmaller than France with 8% of Brazil’sland mass. High taxes and governmentregulation and corruption also detergrowth. Real estate speculation isrampant.
The government and central bank aretrying to curb foreign money inflows andtheir boosting effects on the real, butwith limited success. Some of theirrecent moves strike us as desperate.President Dilma Rousseff just announcedplans to hype falling industrial productionthat’s resulted from high interest costsand cheap imports from China andelsewhere. She’s calling for payroll taxcuts for manufacturers, more subsidizedloans and favoring Brazilian products byallowing the government to pay morefor local products than imports, especiallyhealth, defense, communications andhigh tech equipment—a brand of "BuyBrazil" protectionism.
To demonstrate what the differencebetween near-zero interest rates in Japanand 12.5% rates in Brazil will do, considerthe “double decker” funds developedfor Japanese investors who are hungryfor yield. Those combine high-returnassets with high-yield currencies. Tohigh-yielding stocks and bonds are addedforeign exchange derivatives in equalface amounts. One fund, MitsubishiUFJ Bond Currency Select Brazilian
Chinese GDP
Source: Chinese National Bureau of Statistics
CHART 83
Last Point 2Q 2011: 9.5%
Peak Qtr.1995-PeakPeak-Current
year/year % change
2005 2006 2007 2008 2009 2010 20115%
6%
7%
8%
9%
10%
11%
12%
5%
6%
7%
8%
9%
10%
11%
12%
Australian Target Rate and Foreign Exchange Rate
Source: Thomson Reuters and Reserve Bank of Australia
Real (that's a mouthful), has a dividendyield of 21% and an annualized return of17% over the last two years.
Australia
Australia is a developed country, ofcourse, but also caught up in thecommodity bubble aided and abetted byclose to zero financial costs for U.S.dollars and yen. She also has highinterest rates and a strong Australiandollar (Chart 82, page 33) that are hurtingthe non-mining economy but attractingforeign money like a queen attracts myhoney bees. Economic growth forecastsfor 2011 are being cranked down.
As we’ve noted in past Insights, Australia’smining sector has close links to China,which has been buying huge quantitiesof iron ore, copper, etc. from the islandcontinent. But we continue to predict ahard landing in China, with GDP growthfalling from double digits to 5% to 6%(Chart 83, page 33) as she curtails herproperty bubble and the inflation spawnedby massive stimuli in 2009. That will, webelieve, be curtains for the globalcommodities bubble that is underpinnedby China, and the end of Australia’smining boom.
Meanwhile, Australia’s property boomshows signs of folding (Chart 84, page33). Residential prices are down 2.7%so far this year in major cities andmortgage delinquencies are at all-timehighs. In the last year, first-timehomebuyers have dropped 35% to aseven-year low. Australia’s four largestbanks, which hold over 80% of thenation’s mortgages, could be troubled ifhome price declines persist.
Near-zero interest rates in majordeveloped lands have inspired capitalinflows, and the resulting strongcurrencies, high interest rates andpotential economic problems in manydeveloping countries. Recently, thecurrencies of Singapore, South Korea,Malaysia, the Philippines and Thailandall reached their highest levels againstthe buck in over a decade. Rapideconomic growth in those countries alsomakes them attractive as does the
prospects of even higher currencyvalues. In early August, the centralbanks of South Korea, the Philippinesand Thailand felt compelled to interveneby selling their currencies to forestallfurther appreciation.
Note, however, that these volatile andexport-led economies can go from feastto famine in a hurry. That happened inthe late 1990s when excess foreign debtsled to financial collapse throughout Asiaand Latin America. We wonder if thosenow pouring money into those landseven remember that debacle.
Commodities
We’ve already discussed how cheapmoney encourages commodityspeculation by holding down the cost ofcarrying these goods (Chart 45). Thebubble is so well developed that even thecommodity price declines since earlythis year don’t faze the bulls (Chart 18and Chart 85, opposite page). Indeed, theyare convinced that robust commodityprices are here to stay, despite repeatedhistoric evidence that human ingenuityalways, always eliminates shortages bypushing supply above demand.
Barclays Capital issued a recent 200-page report that sees commodity demand,especially from China and India,continuing to outrun supplies. The studyforecasts exponential growth incommodity usage in those lands as theymove up the developmental scale. Ithighlights corn, copper and crude oil as“already driven by longer-term scarcityissues” and says their prices are relativelyimmune from debt-related weakness inthe U.S. and Europe because demand is“relatively robust and supply risksabound.”
Savers Mauled
As we’ve been discussing, near-zerointerest rates have distorted the financialand economic scene by pushing manyinvestors into risky investments in foreignlands, commodities, junk securities andother investments they may come toregret. But many remain in bank CDsand money market funds for safety
Money market 7-day interest returns inAugust were a trivial 0.03%, and theywould have been negative in many casesif fund managers had not waived theirfees (Chart 86, page 34). And thiscondition will likely persist. The federalfunds rate target, which rules other short-term returns, has been in the 0 to 0.25%range for three years, and the Fed intendsto keep it there for two more years,barring a burst of inflation or a big dropin unemployment, as mentioned earlier.
In early 2007, those 7-day money marketyields ran around 5% but collapsed toalmost zero on that $2.5 trillion ofsavers’ assets. Six-month CDs yieldedover 5% in early 2007, but are nowbelow 0.4%. Money market funds usedto be cash machines, generating $13billion in fees at their peak in 2008, buttheir revenues have dropped 65% in thelast three years as short-term ratesplummeted and assets shrank (Chart 87,page 34). A number of funds havefolded, with the total dropping from 805at the end of 2007 to 652 at the close of2010.
As noted earlier, at the beginning ofAugust, Bank of New York Mellonreacted to the surge in inflows incorporate cash by charging 0.13% ondeposits over $50 million. That'sunderstandable because the bank earnsalmost a zero return on short-term moneyand pays FDIC fees of about 0.10% ondeposits. Bigger deposits also forcebanks to hold more capital, which alsodepresses profits.
Insight readers may recall my Feb. 2010Commentary, “A Great Idea At TheTime.” Years ago, I wanted to impressmy kids and maybe grandchildren withthe power of compound interest so inApril 1991 I made no furthercontributions to a small money marketaccount I’d held for years to let itaccumulate purely on compound interest.It was worth $23,417 then, and if theyield of 5.7% continued for the next 19years, it would compound my accountby 187% to $67,137.
Even though I was forecasting lower inflation if notdeflation and much lower Treasury bond yields as a result,I forgot that short-term money market rates would fall aswell. So rather than compound to $67,137, my $23,417only reached $47,131 19 years later as money market ratesfell and then collapsed. And the recent 0.1% annual returnwould compound my account’s value by a trivial $2 overthe next 19 years. So I moved to Plan B, and encouragedour four children to save more since they can’t expect theirinvestments to build huge assets.
Save More or Less?
Will Americans be discouraged by low returns and save less,or will they save more to reach lifetime goals? They'll dothe latter, in our judgment, which is one more reason whywe expect the saving rate to jump back to double digits(Chart 51). Others, which we’ve discussed many times,include distrust of volatile stocks, the shrinking houseappreciation that was tapped earlier to fund oversizedspending, the postwar babies’ desperate need to save forretirement and chronic high unemployment, whichencourages saving for contingencies.
Low returns for savers as well as still-depressed retirementaccounts, further increases in the Social Security retirementage and uncertain futures will also encourage many to work
longer. Labor participation rates for those over 65 will nodoubt rise (Chart 88, page 35). As seniors stay in their jobs,however, openings for youths may be curtailed.
E Bonds
Low returns on money market accounts and other savingvehicles have also encouraged Americans to move moneyto FDIC-insured bank accounts, as has the rush forliquidity discussed earlier. Money market fund assetscontinue to erode (Chart 87). It’s also renewed interest ingovernment E bonds, popular in the patriotic days of WorldWar II. These 20-year government-guaranteed obligationspromise to double the initial investment if held to maturity.In the meanwhile, their principal compounds at the 10-yearTreasury rate, now about 2%.
If that rate persists for 20 years, the principal will compoundto $149 for each $100 initial investment, but the Treasurywill make a one-time adjustment of $51 at the end so thebond matures at $200. Doubling in 20 years requires anannual 3.53% rate of compound interest. The E bond,then, is essentially a 20-year zero-coupon if held to maturity,and the market rate on 20-year zeros is now 3.6%, aboutthe same. But the E bond has no further opportunity forappreciation if rates fall—the only reason we've even heldTreasurys in coupon or zero-coupon form. And you have
Real GDP (% chg.)Nominal GDP (% bil.)PCE Price Index (% chg.)Core PCE Price Indexa (% chg.)CPIb (% chg.)Core CPIc (% chg.)GDP Price Index (% chg.)Employment Cost Index5 (% chg.)
Wages and Salaries ($ bil.) Domestic Economic Profits
Nominal GDP ($ billion)d
2.54.01.91.12.51.21.51.7
9.10.13.2
43.5
8.76,5641,314
15,095
2.53.81.71.51.81.51.22.7
8.80.13.2
43.9
8.46,8691,321
15,663
2.03.31.31.41.31.41.32.9
8.60.23.3
44.2
8.27,1471,325
15,663
3.44.91.31.41.31.41.43.2
8.30.63.6
44.2
8.47,5041,430
16,974
5.36.81.51.51.61.61.53.5
6.51.64.2
44.5
8.68,0781,552
18,132
3.65.41.81.72.01.91.73.6
5.42.94.8
45.0
8.18,5901,552
19,110
2.84.81.91.92.22.11.93.5
5.23.95.2
45.0
7.79,0191,537
20,028
2.64.62.02.02.32.22.03.7
5.24.05.3
45.1
7.49,4521,554
20,948
2.54.62.02.02.32.22.03.6
5.24.05.3
45.2
7.49,8981,615
21,901
2.34.42.02.02.32.22.03.5
5.24.05.3
45.3
7.210,3491,654
22,856
2.34.32.02.02.32.22.03.3
5.24.05.3
45.3
7.010,8051,676
23,830
a. excludes prices for food and energyb. CPI for all urban consumersc. employment cost index for wages and salaries of workers in private industryd. these values do not incorporate the July 2011 revisions of the national income and product accounts
to live and hold the E bond 20 years to collect the doublein principal.
Persistent low returns for savers as well as the related highchronic unemployment, general uncertainty, recession fearsand the resulting low levels of consumer confidence (Chart19) will continue to curtail consumer spending. And lowconfidence can become a self-fulfilling prophecy ashouseholds withhold outlays. Consumer goods producerslike Procter & Gamble are wary of consumers watchingtheir pennies and switching to cheaper house brands whilehigher commodity costs erode their gross margins. Evenhigh-end retailers fret, knowing their customers are sensitiveto stock market losses. And the recent slides in their stocksreflect this sensitivity. The top 20% by household incomehold 89% of equities.
Century Bonds
Low interest rates are not only troublingfor household savers but also forinstitutional investors. Insurers largelyinvest in bonds, and the declining yieldson their portfolios (Chart 89, page 35) areforcing them to cut benefits, design less-generous policies and raise prices wherecompetition will allow.
Lower stock prices and lower bondyields (Chart 90, page 35) have slashedthe assets of S&P 500 pension plans inrelation to their future obligations from85% at the beginning of the year to anestimated 75% in mid-August (Chart 91,page 36). With many pension funds still
Federal Government Net Interest Payments
* net interest=interest payments-to-debt held by the public Source: Office of Management and Budget
CHART 96
Last Points 2010: interest/GDP 1.37%; interest/expenditures 3.95%
1948 1958 1968 1978 1988 1998 20081.2%
1.4%
1.6%
1.8%
2.0%
2.2%
2.4%
2.6%
2.8%
3.0%
3.2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
Net Interest / GDP - left axis
Net Interest / Govt Expenditures - right axis
expecting unrealistically high returns on assets and alsounderestimating the present value of future benefits, theirfunding status may continue to drop. Ditto for statepension plans. The median asset return assumption for 126of them is 8%, far above recent and likely future returns.
On the flip side, low rates have encouraged many investment-grade corporations to refinance existing debt at lower rates.So have two-thirds of the junk bonds issued since 2009.Then there are the century bonds, which lock in currentrates for the next 100 years. Mexico recently added to her$1 billion century bond issued last October. In May, MITissued $750 million in 100-year obligations—firm assurancethat that fine institution will be around for a century.
In that month, Norfolk Southern issued $100 million in100-year bonds. Berkshire Hathaway and P&G also
locked up borrowing for 100 years as did RobobankNederland, Coca-Cola and Motorola. In early August, theUniversity of Southern California issued $300 million incentury bonds with a 5.25% coupon yield. That interestcost for 100 years compares with the 3.4% yield on muchshorter 30-year Treasury bonds at that time. Is the extra1.85 percentage points interest for another 70 years ofmaturity worth it? The relatively small extra rewardsuggests that buyers of this issue agree with us that inflationis dead for many years.
CBO Forecasts
In last month’s Insight article, “Debt Bomb?,” our analysisslowed how important interest rates are to interest paid onthe federal debt, the resulting contribution to deficits andto the growth in the debt total. As we noted then, theaverage maturity on the public U.S. debt outstanding wasonly 4.75% in 2010 (Chart 92, page 36), at the low end ofthe yield curve (Chart 33). Furthermore, long-termTreasurys’ share of the debt outstanding has shrunk in thelast decade (Chart 93, page 36).
The nonpartisan Congressional Budget office’s newprojections, which incorporate the reductions in federalspending enacted in August but also assume that the Bushtax cuts will expire on schedule, result in deficits totaling$3.5 trillion over the next decade, down from the $7 trillionforecast in January. The CBO assumes that GDP growthbasically catches up from the depressed rates of recentyears, rising to 5.0% annual growth in 2015 before droppingback to 2.3% in 2020 and 2021 (Chart 94, page 37).
In contrast, we see slower annual growth, 2.0%, throughoutthe decade. The unemployment rate is assumed by theCBO to drop back to 5.2%, again very optimistic in ourjudgment. Faster economic growth propels taxes andthereby restrains the deficit while also reducing the deficit-to-GDP and debt-to-GDP ratios by enlarging theirdenominators. Lower unemployment also eliminates thedeficit-enhancing pressure to create more jobs that concernsus.
The CBO sees 3-month Treasury bill rates rising graduallyto 4.0% over the next decade and 10-year Treasury noteyields to 5.3% (Chart 94). Its net interest paid projectionsdivided by the CBO's debt forecasts yield its effectiveinterest rate for financing the debt, and it rises from 2.2%last year to 4.6% in 2021 (Chart 95, opposite page). As aresult, net interest-to-GDP peaks at 2.8% in 2020, belowthe earlier peak of 3.2% reached in 191 (Chart 96, oppositepage).
Even with the CBO’s assumptions that the effectiveinterest rate on the federal debt jumps from 2.2% to 4.6%,interest costs-to-GDP does not skyrocket. With ourprojection of no rise in interest rates over the next decade,interest costs-to-GDP reaches only 2.4% in 2021 even ifwe assume that the debt held by the public rises $1 trillionper year for a decade and nominal GDP rises only 2%annually (Chart 97). Either way, relatively low interest ratesin future years will help contain interest paid-to-GDP ratiosfor the federal government and, therefore, growth in thegovernment deficits and debt.
CHART 97Interest Payments and GDP
Assumes 2% growth rate in GDP and constant $1 trillion increases in public debt outstanding Source: Yahoo Finance
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
$14,660
$14,954
$15,253
$15,558
$15,869
$16,186
$16,510
$16,840
$17,177
$17,521
$17,871
$18,228
$9,018
$10,018
$11,018
$12,018
$13,018
$14,018
$15,018
$16,018
$17,018
$18,018
$19,018
$20,018
62%
67%
72%
77%
82%
87%
91%
95%
99%
103%
106%
110%
2.16%
2.16%
2.16%
2.16%
2.16%
2.16%
2.16%
2.16%
2.16%
2.16%
2.16%
2.16%
1.4%
1.4%
1.6%
1.7%
1.8%
1.9%
2.0%
2.1%
2.1%
2.2%
2.3%
2.4%
GDP ($ bil.)Public Debt
($ bil.) Debt/GDP
Avg.Interest
Rate
InterestPayments asa % of GDP
40 A. Gary Shilling's INSIGHT September 2011Telephone: 973-467-0070
If you enjoy reading Gary Shilling's monthly "Commentary," you may be interested in Letting Off Steam, a collection of more than 130 ofGary's "Commentaries" from 1989 through 2003. This 286-page book is available for $20 (shipping included). Call 973-467-0070 to order.
Commentary
Family Vacations
In the 1962 movie, “Mr. Hobbs TakesA Vacation,” Jimmy Stewart takes hiswife and kids to a waterfront rentalhouse for a family vacation. The filmis entirely a flashback of a long letterdictated to his secretary (they tookdictation back then) and to be openedby his wife after his death. So youknow from the outset that this vacationwasn’t entirely a pleasurableexperience.
Mr. Hobbs envisions a quiet stay withlots of bonding time with his family.Wishful thinking! When they arrive,his son-in-law’s hands are glued in hispockets, so Mr. Hobbs has to lug allthe baggage up multiple flights ofstairs to the house. His plans for akick-off family drink evaporate aseveryone takes off for some reasonor another and he ends up having thatdrink alone. Almost no subsequenttime is spent together as a family, andanother daughter falls for a localtownie, much to the initialconsternation of Mr. and Mrs. Hobbs.
In the early 1990s, my wife and Iessentially rebuilt our beach house onFire Island, off the south coast ofLong Island. (Incidentally, the housesurvived tropical storm Irene in fineshape, except for the usual six inchesof water in my boat shed, my toolshed and in the storage spaces underthe house.) We wanted a nice placethat would bring back our four kids inthe summer with their families as theywere accumulated.
That strategy basically works well,and all four usually spend time with useach summer. In fact, one of thembought his own house five doorsdown the bay a few years ago. Every
year, I look to repeat the great dinnerswe all had together back when thekids were in college. Everyonepursued their own interests duringthe day—tennis, sailing, biking orswimming while I was fixing somethingor another or tending my gardens.But we all ate together overlookingGreat South Bay at a huge table I hadmade from two post oak trees fromour property that unfortunately died.The kids’ friends would stop by for adrink and dessert, and we’d talk andlaugh by candlelight until well past myusual early bedtime.
But all those memories are ancienthistory, as I've learned in recentsummers. Things have changed;they’re different. And they’rechallenging for my wife and me, whokeep an orderly house and expectthings to be pretty much where welast left them.
Our kids are now in their 40s, and alldefinitely live their own lives,individually and as families. Theyhave many friends in our community,so they’re out not only for daytimeactivities, but also often for cocktailsand dinner. We’re happy to have ourkids invite their friends to stay withus, but naturally our offspring want tospend time with those folks. And Ihate to ask men in clean white tennistogs to help me move boats.
Some of our kids have quite adifferent concept of orderliness, andit’s a challenge to keep my mouth shutwhile not tripping over all the clothes,toys and other assorted items that liketo live on the floor. Our children andthe cleaning help they hire do cleanthings up periodically, however.
This summer, I took out the woodwe’d need to build birdhouses, figuringthat one grandson was old enough toenjoy a project with Pops, as our
grandchildren call me. I learned thatyoungsters today have their ownactivities and don’t have the sameview of their grandparents that I didyears ago. So, sadly, I took the woodback home.
I sometime wonder if our kids viewour beach house as a family vacationplace or as a glorified hotel. My wife,Peggy, however, rightfully andcontinually reminds me that thingsare different now and we need toaccept reality if we want to enjoy ourfamily each summer. And, of course,we see only our side and don’t realizehow much our kids are adjusting toaccommodate us.
In mid-August, Peggy and I had dinnerwith close friends John and AnneDockery at the Club in this beachcommunity. Their two marrieddaughters are about the same ages asour kids so we compared notes onfamily vacations. The catharsis washelpful for all four of us as was therealization by both couples that wearen’t alone in adjusting to vacationswith intelligent, active and thoroughlyindependent grown offspring.
At the end of the Mr. Hobbs movie,we’re back in his office and hissecretary, after many memo pads’worth of dictation, tells him he mustbe glad he’ll never see that vacationhouse again. Oh, no, he replies, we’vealready rented it for next year. Wefeel the same way. Family vacationsrequire accommodation on all sides.But Peggy and I want to make surethat our kids and their families keepcoming back every year. Althoughless frequent, we still have great familydinners at that oak table.
