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As
long-time readers know, my daughter Tiffani and I are interviewing millionaires
for a book we will be writing called Eavesdropping
on Millionaires. This has been one of the more personally impacting
projects of my life, as the stories we hear are so very provocative. I hope we
can transfer to readers of the book at least half of the impact we are
personally experiencing. But at the end of each interview, we let the
interviewee ask me questions. Often, they are along the line of "Do you really
think we will Muddle Through?" Sometimes they ask in need of assurance and
sometimes they simply think that my stance is somewhat naïve. It is something of
an irony that I am called a perma-bear in some circles and a Pollyanna in
others. The Muddle Through middle has been lonely of late.
So,
this week I take another look at my Muddle Through stance. We look at some of
the recent data on unemployment and retail sales, think about the implications
of a falling trade deficit and a rising US government deficit, speculate about
the potential for a serious stock market rally, and also comment on the
potential for a GM bailout. There is a lot to cover, so let's jump right in.
Where Have All the Consumers Gone?
Retail
sales and prices of goods imported to the US dropped by the most on record,
signaling the economy may be in its worst slump in decades. Purchases
fell 2.8 % in October, the fourth straight decline, the Commerce Department
said today in Washington. Labor Department figures showed import prices
dropped 4.7%, pointing to a rising danger of deflation, and a private report
said consumer confidence this month remained near the lowest level since 1980.
(Bloomberg)
Circuit
City filed for bankruptcy and Best Buy said sales were down and gave even lower
guidance for Christmas. Nordstrom's cut its profit forecast for the third time
this year.
It is a perfect storm for
retailers. Consumers are having a negative wealth effect as stock and housing
prices have plunged, taking almost $20 trillion out of US consumer assets.
Unemployment is rising and consumer confidence is at the lowest levels since
the last major recession in 1980-82.
The unemployment numbers
which came out this week were particularly grim. Jobless claims on a
seasonally adjusted basis were 516,000 newly unemployed. But that masked an
even deeper actual number of 540,000. The largest previous number for this week
was back in 2001 and was 420,000. Actual weekly numbers can be volatile, but
such an increase is certainly disconcerting.
I should point out that as of the
end of September there were 3.3 million job openings, down slightly from
August. It is not as if there are no jobs being created or available. But as
pointed out last week, the number of people looking for work for over 8 months
is high and rising fast, so there is a serious mismatch of the jobs available
and the desire or ability of people to take them.
Continuing
claims are now at roughly 3.5 million individuals who are getting unemployment
insurance. Let's assume that each week we lose an average of 400,000 jobs. That
is 20 million jobs a year. That means the US economy for the last year has
created 16.5 million jobs (very roughly). So there is some robustness in the
economy even as we slide deeper into recession.
But
what happens if we see the number of new unemployment claims start to rise to
an average of 500,000 for a period of time? Without more job creation, that
would mean an increase in unemployment of 1,000,000 people in just 10 weeks.
This week we have seen an increase in continuing claims of 141,000 from just
last week. That, gentle reader, is very grim if it were to continue.
Unemployment is likely to continue to rise throughout most of 2009, closing in
on 8%.
This
time of year should see some seasonal rise as retailers begin to hire for
Christmas. But with retail sales down and facing the likely prospect of negative
growth in Christmas sales for the first time ever, seasonal employment is
evidently not responding. More comments on this below as I take up the Muddle
Through economy.
Why Is the Dollar Rising?
The
trade deficit is dropping slowly, from over $60 billion in July to $56 billion
in September. Import prices fell and imports were down by 5.6%. On a less
positive note, exports, which had been one of the bright spots in the economy,
fell by 6%. The trade deficit would have been another $3 billion less if Boeing
had not been on strike.
Oil
prices were an average of $104 a barrel in September. For November prices will
be closer to $65, down at least one third. That means the possible trade
deficit for November could be a lot closer to $40 billion, the lowest since
2003 and well off the highs of almost $68 billion a few years ago.
Why
is this important? Two reasons. First, it means that a lot fewer dollars are
now going into the world economy. And demand for dollars is rising as the world
seeks a safe haven in the current global recession, so it should not be a
surprise that the dollar is rising.
The
surprise is the violence, the amazing rapidity of the rise. We are seeing
movements in currency prices in a week that would normally be a year's worth of
volatility. It is a sign of the severity of the crisis, of the wariness of
traders, that prices are so volatile.
Second,
it also means fewer dollars will be coming back into the US to finance the
rising government deficits. As Woody Brock (one of my favorite economists) in a
recent essay points out, this is counter-intuitive, but it is nonetheless true.
Dollars which go abroad must eventually find a home,
and that home is going to be in US assets of some kind, usually government
bonds.
Some
worry about China or another large country might stop buying US bonds with
their dollars. They worry that they might want to increase their holdings of
euros, for example. But what that means is they take the dollars and sell them
to someone who has euros. Then that country has dollars that they must then do
something with. It is not as if the dollars disappear.
The
only way for China (and/or the world) to really reduce their dollar balances is
to stop selling products to the US consumer or to buy US assets like stocks or
real estate or wheat, thus bringing the dollars back to the US.
But
what in practice happens is that China and most Mideast countries on a net
basis buy US government-backed debt. But if there are fewer dollars going
abroad, that means there are fewer dollars to buy newly issued debt. And our
government is issuing new debt at a rather startling rate.
The
estimates for the deficit next year are close to $1 trillion. But if the trade
deficit is "only" $500 billion, that means that the
appetite of foreigners for US debt will be less than half what is needed to
finance the deficit. Where does the difference come from? US citizens and
corporations, primarily banks, are going to have to buy the difference or the
Fed will have to monetize a portion. Or rates on longer-term debt could go high
enough to entice foreigners to buy US debt.
Higher rates would be a drag on the
US economy and especially the housing markets and would also cost the taxpayer
a lot in additional interest-rate expenses. Total government debt is now $10.5
trillion, with the public (including non-US holdings) having $6.3 trillion. The
average interest rate paid on that debt is 4.009%, and for fiscal year 2008,
which ended October 31, the interest expense was $451 billion. Add another
trillion and the interest paid would soon rise to $500 billion.
The US will face a serious problem
in 2009. Tax revenues are going to take a very serious fall. Remember when
capital gains taxes would produce a few hundred billion? Not in 2009. And
income taxes will drop as unemployment expenses rise. The perceived need for
government stimulus will be offset by the problem of funding the deficit.
Resorting to monetizing the debt is a nuclear option. Expect even more
volatility in the currency and interest-rate markets next year.
Can We Actually Muddle Through?
In
addition to the above, let me list a few problems I have highlighted in the
past few months. Roughly 3% of GDP growth for 2002-2007 was from Mortgage
Equity Withdrawals and other debt. That stimulus is gone. Consumers are going
to start saving once again, taking money from a consumer-spending-driven
economy. Taxes are likely to rise, not only at the federal but
at the state and local levels, as governments of all sizes are faced with
growing deficits and needs. Financial institutions are deleveraging at a very
fast pace. It is, as one friend told me, as if the economy at large is facing a
massive margin call.
Given
all of the above problems, how is it possible that we can Muddle Through?
In
January of 2007 I forecast a mild recession beginning in late 2007. I was early.
In January of this year, I still thought the recession would be more like that
of 1990-91. Clearly, I was an optimist. It is now likely that we will see a
recession as deep as 1974. This quarter is likely to see a negative growth
number of 4% or more. That is deep by any standard. And I do not think that the
economy will begin to actually grow before the third quarter at the earliest.
It is quite likely that 2009 will be negative for the entire year, and possibly
for all four quarters.
We
are, as I have said, hitting the reset button on consumer spending. We are
going to some lower level of consumer spending, and corporations and government
are going to have to adjust their budgets. Corporate earnings will be under
pressure for some time to come.
But,
and this is a big but, this too shall pass. At some point we will hit a bottom.
Just as irrational exuberance led us into foolish actions, we are now becoming
too pessimistic. The pendulum will swing. Minsky taught us that stability breeds instability.
The more stable things are, the more comfortable we are with taking risk,
which ultimately creates the conditions for a normal business-cycle recession.
This time, we took on a whole lot more risk than usual and are facing a deeper
recession.
But
the opposite is true as well. Instability will breed stability. It is, as Paul McCulley calls it, a
reverse Minsky moment. We will adjust to the new environment by becoming more
conservative. And that new conservative environment will bring about a new stability,
albeit at lower levels. But it will be a level from which we can begin to grow
once again. It has been this way since the Medes were trading with the
Persians.
And
here is where I may not have been clear, as the conversations mentioned at the
beginning of the letter have called to my attention. My thought is that Muddle
Through is the period after we are finished with the recession. I think that
the future recovery when it comes will be a lot slower and longer in getting
back to trend growth than normal. It will be a Muddle Through, slow-growth
economy. I expect that period to now last through at least 2010. The credit
crisis and the housing bubble are not problems that can be quickly or easily fixed.
It will take time.
The Potential for a Large Stock Market Rally
Everyone
knows that there are large amounts of hedge fund redemptions being processed.
Some blame the current vicious sell-off on forced hedge fund sales
as they have to meet these redemptions at the end of the quarter.
This
brings up an interesting possibility. My guess is that the large bulk of that
money is going back to institutions that will need to put the money to work.
Where will they deploy it? If they are projecting 7-8% total portfolio returns,
they cannot put that money in bonds. My guess is that it will go back to other
hedge funds or into long-only managers. This money will start to go to work in mid- to late January. We could see a very large rally
the first quarter of next year. For traders, this will be a chance to make some
money. I think it will be a bear market rally, as the recession will still be
in full swing, and we could see a pullback when that money gets fully deployed.
But it will be fun while it lasts.
As
traders begin to sense that possibility, we could see a serious year-end rally
as well. Would I bet the farm? No, but I offer up the idea as a possibility.
And I know a lot of people have large short positions that have made them a lot
of money this year. Maybe it is time to think about taking profits.
And now a few
thoughts on the possibility of bailing out GM.
Is GM too Big to Let Fail?
(Let
me say at the outset I am truly sorry for those who have lost their jobs or are
facing the possibility of a job loss, whether at GM or any other firm. I have
been there, as have most people at one time or another.)
I
wrote in 2004 that GM was essentially bankrupt. They owed more in pension
obligations than it seemed likely they would be able to pay, without major
restructuring of the union contracts.
I was not alone in such an assessment, although there were not many of
us. Now that assessment is common wisdom.
Bloomberg
today cites sources that claim a collapse of GM would cost taxpayers $200
billion if the company were forced to liquidate. The projections also called
for the loss of "millions" of auto-related jobs. GM, Ford, and Chrysler employ
240,000. They provide healthcare to 2 million, pension benefits to
775,000. Another 5 million jobs are directly related to the three auto
companies. GM has 6,000 dealerships which employ
344,000 people. According to a recent study by the Center for Automotive
Research (CAR), if the domestic automakers cut output and employment by 50
percent, nearly 2.5 million jobs would be lost and governments would lose $108 billion
in revenue over three years. (Edd Snyder at Roadtrip blog)
How
did we get to a place where the market cap of GM is a mere $1.8 billion and its
stock price has dropped from $87 in early 1999 to $3.10 today? (See chart
below.) Where Rod Lache of Deutsche Bank has a "price target" of zero for GM?
"Even if GM succeeds in averting a bankruptcy, we believe that the company's
future path is likely to be bankruptcy-like," Lache wrote.
The
litany of reasons is long. At the top of the list are union contracts
which mandate high costs and pension plans which cannot be met. Then
there is the problem of many years of poorly designed cars, although they are
now getting their act together. We can also discuss poor management and bloated
costs, like paying multiple thousands of workers who are not actually working.
GM is structured for the 50% market share they used to command, whereas now
they only have 20%.
Wilbur
Ross, a well-known multi-billionaire investor, was on CNBC saying that allowing
GM to go bankrupt would throw the country into what sounded like a depression.
Of course, he does have an auto parts company which supplies GM; so he, as my
Dad would say, does have a dog in that hunt.
Ross
said that we as a nation are to blame for GM's problems (I am not making this
up) because we do not have a national industrial policy. The US allowed other
automotive companies to build plants in states that had lower labor costs, and
that is the reason GM is uncompetitive. GM pays an average of $33 an hour, and
those selfish other companies pay a mere $19 plus a host of benefits.
Ross
evidently believes that because some states have lower taxes and right to work
laws, that it is the responsibility of the taxpayer to give GM a certain type
of immortality rather than suggest GM deal with its problems directly. I assume
that Ross also sides with the French when they suggest that Ireland should
raise taxes so they will not have to compete with Ireland for business. Such
thinking is nonsense and is also unconstitutional.
Let's
all acknowledge that having GM go bankrupt would not be a good thing. But it is
not the end of the US automotive industry, nor even of
GM. Let's think about what a GM bankruptcy might look like. In a bankruptcy,
the debt holders line up to come up with a restructuring plan so that they can
maximize the return of their loans or obligations. The shareholders get wiped
out, but with GM down over 95%, that has largely been accomplished. That
process has happened with airlines, steel companies, and tens of thousand of
other companies. It is called creative destruction.
First, let's understand that the
real owners of GM are the pension plans, as I wrote in 2004. They are the
entities with the largest obligations and the most to lose. They are the
biggest stakeholders in a successful GM. Giving them the responsibility for
making a new, leaner, meaner GM with realistic union contracts would be
rational; otherwise they would lose most of what they have.
Factories need to be closed. Auto
sales are down to 11 million cars a year, the lowest since 1982, which was the
last major recession. Automotive companies sold cars at such low prices in the
last few years that sales went to 16 million a year. But the cars that have
been sold will last for a long time. Few people are going to buy a new car when
the old one is working fine, especially in a recession and a Muddle Through economy.
Further, does GM really need eight automotive lines, some of which have been
losing money for years?
A restructured GM with realistic
costs could be quite competitive. They have some great cars. I drive one. It is
four years old and so good I am likely to drive it for at least another four.
At some point after the restructuring,
the pension plans could float the stock on the market and get some real value.
If actual pensions need to be adjusted, then so be it. While that is sad for
the GM pensioners, is it any sadder than for Delta or United Airlines or steel
company pensioners who saw their benefits go down? For the vast majority of
Americans, no one guarantees their full retirement. Why should auto trade
unions be any different?
Taxpayers in one form or another
are going to have to pay something. Unemployment costs, increased contributions
to the Pension Benefit Guarantee Corporation, job training, relocation, and
other costs will be borne. So, it is in our interest to get involved so as to
minimize our costs, as well as help preserve as many jobs as possible.
Sadly, I think it is likely that a
Democratic majority next year will quickly pass a bailout that will not solve
any of the longer-term problems. Obama evidently wants to appoint an
"automotive czar;" and the name being floated is the very liberal Michigan former
Representative David Bonior, whose anti-trade and pro-union positions are well
known. This is appointing the fox to guard the hen house. It is not a recipe
for the restructuring that is needed.
The bailout for GM is a bailout for
the trade unions and management (who not coincidentally both made large
contributions to the Democratic Party and candidates). US consumers are simply
going to buy fewer cars in the future. That is a fact. Spending $50 billion
does not address that reality. That $50 billion can be better spent by helping
workers who lose their jobs. Without serious reforms a bailout will simply
postpone the problem, and there will be a need for more money in a few years.
And do we think that the management which got GM into the
current mess is the group to bring them out?
And as to the argument that "We
bailed out Wall Street, so why not GM?" it doesn't hold water. What we did and
are doing is to try and keep the financial system functioning, so we don't see
the world economy simply shut down. But don't tell the 125,000 people who have
lost jobs on Wall Street that it was a bailout. That number is likely to go to
200,000. No one thinks that a restructured GM would see anywhere close to half
that number of job losses.
Do we protect Circuit City? Sun
just announced plans to lay off 6,000 workers. Where is their bailout? Citibank
announced 10,000 further job cuts today. This is a
recession. And sadly that means a lot of jobs are going to be lost. GM workers
should have no more right to their jobs than a Sun or Citibank or Circuit City
worker.
Now, would I be opposed to a bridge
loan to help in the transition? No, because a viable Detroit is good for the
country and will cost the taxpayer less in the long run than if we have to pick
up their pension benefits. But any money must come with realistic reforms that
put in charge new management and a realistic cost structure so GM can compete.
New York, Moving, and Another One Leaves the Nest
Today,
while I am writing this letter, my #2 son Chad is moving out, to an apartment
not far from me, but still no longer in the house. He is 20 and eager to be on
his own. He has recently taken a job at Best Buy, while trying to decide what
to do next. I am happy for him, as you can clearly see the anticipation on his
face. Six down and one left. Trey, the youngest, is 14, and I suppose the day
will come when he too decides it is time to be on his own. That
is what we as parents hope for. But there is a part of
me that will miss Chad being under my roof.
Thanksgiving
is coming up and I am making plans, not just for the usual big dinner but also
for moving that weekend to another home not too far away. I will move my office
into the same house in mid-December. The savings will be substantial, but the
savings in commute time will be even more valuable. I will miss this Ballpark
office, though.
I
will be in New York next month (December 4) for Festivus, a holiday fundraiser
sponsored by my friends at Minyanville.com. If you are there, be sure and look
me up. It will be a fun weekend, as there will be dinners with friends, and
Barry Habib (of the Mortgage Market Guide
and one of the show's producers) has arranged for tickets to the musical Rock of Ages.
It is quite late. For some reason,
this letter was harder to write than usual, but even letter writing comes to an
eventual end. Have a great week.
Your ready already for recovery analyst,
John Mauldin
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Copyright 2008 John Mauldin. All Rights Reserved
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