Forecast Notes

Underlying thesis: the problem of too much debt has not gone away and in fact has gotten worse as the ability to service it has deteriorated, not improved; housing values, the original foundation for all that debt, is still overvalued relative to historic norms and due to fall further; these factors have to be normalized before we will have any sustainable recovery; government interventions are intended to restart the credit cycle and as such are self-defeating

The bursting of the debt bubble is deflationary; the policy response is intended to offset this, and the market is worried that it will be excessive and prove inflationary

Reasonable people can disagree, each with their own good reasons, on this debate; I, for one, remain firmly in the deflationary camp; I believe that government is too small relative to the size of the private economy to offset the downside forces in the broader economy; further, the regular channels of policy traction do not work in a deeply-entrenched credit crunch that is accompanied by serious asset devaluation

For example, the Fed has doubled the monetary base to $1.7T, and may increase it further to $2T or $3T; but that’s still small relative to the $14T of household debt outstanding or the $52.6T of total credit market debt outstanding

furthermore, the monetary base has expanded but has been achieved just by doubling excess reserves at depository institutions to $0.77T, and the banks are just sitting on that; normally, increasing excess reserves would motivate banks to increase lending, because sitting on the money has an opportunity cost, and there would be a significant money multiplier effect due to the nature of the fractional reserve lending system; however, no matter how much reserves are increased now, there is no incentive to increase lending to an already overly-debt burdened and contracting private economy, and every incentive not to given the credit risks involved, and also given that due to the risk of deflation, a dollar tomorrow will be worth more than a dollar today

The Fed’s “printing of money” has not been anything like a helicopter drop; if I were a master counterfeiter and were to fly a helicopter over Toronto and drop millions of perfect hundred dollar bills down all over the city to the public below, it would be like everyone won the lottery, and would certainly lead to incremental spending and economic activity as everyone spent the bulk of their windfall; but that’s not what the Fed has done; what it has done is more akin to me printing a trillion dollars of fake dough then taking it all to my bank and locking it in a safety deposit box; the printing itself does nothing, it’s the dissemination of it that is inflationary

PPIP/TALF/etc useful for solvent banks facing some illiquidity constraints but no panacea for insolvency

Govt still refuses to acknowledge that saving the banks is different than saving the banking system; and whereas the latter is essential, the former is counterproductive; they're using the red herring of the 'no more Lehmans' line as the public justification for their actions when it has a lot more to do with regulatory capture and friends in high places

Despite govt hesitancy to admit and do something about it so far, insolvency, not illiquidity, remains the problem, so there will be more bank failures - big ones; nationalization may be a dirty word for some but bailout has become an even dirtier word so we will, if not soon then ultimately, learn to love the word preprivatization

The writedowns that were never supposed to approach $1T are now well over that ($1.25T) and will exceed $2T if not $3T

It’s not clear that writedowns of mortgages have even peaked yet, given that foreclosures and delinquencies were 11.2% at end of 2008 and still climbing rapidly and home prices are still falling; also, there are many more shoes to drop, particularly credit cards, commercial real estate loans, leveraged loans and, for European banks, Eastern European loans; for instance, the commercial banks are holding their commercial mortgages on their books at average carrying values of 95 cents on the dollar, with many still holding them at 100 cents; construction and industrial loans being carried at 96, construction loans at 90, home equity at 91, etc.; they also have a lot of off-balance sheet stuff still

Leading economic indicators have stabilized but at very low levels, indicating further deterioration though at a slower pace; and LEIs seem to be supported primarily by inclusion of monetary growth, which, given the dropoff in monetary velocity, is not likely to have a stable relationship to how it impacted the economy in normal times

The output gap is wide and getting wider; even if government actions somehow managed to get the economy back to the 2.5% potential real growth rate of the economy (labour force growth of 1.5% and productivity growth of 1%), that would not close the output gap and would not alleviate the deflationary forces; they need to get the economy above potential growth rates to eliminate the deflationary output gap

Nonetheless, nothing goes in a straight line: the U.S. recession may in fact end this year – but, if so, it would then resume early next year before coming even close to regaining the 2007 peak - nasty double dip

Housing may have more false dawns and activity can't fall forever; but crux of the matter is that in environment of worst recession in 75 years with climbing unemployment, falling incomes and a credit crunch, home prices will continue to fall PAST the mean, not just revert to it, which means there is much more home price depreciation to come, so collateral underpinning financial assets will continue to fall in value as will household wealth

U3, now 8.1% but 8.9% NSA, will exceed 10% and U6, now 14.8%, will likely hit 20%; employment-population ratio now under 60% for first time since mid-1980s, despite structural changes in workforce (ie. working females)

Real debt burdens get worse and worse as ability to service debts gets harder and harder - particularly once deflation becomes entrenched - ie not just a commodity phenomenon but a core goods and services one, a la Japan, as excess capacity is rampant throughout the global economy

Vicious circle as aggregate demand is less than aggregate supply --> production cuts --> layoffs and falling incomes --> falling aggregate demand --> rinse and repeat, vicious circle

Europe is a mess; too many countries have too much exposure to loans (banking assets a multiple of gdp) - EUR will fall back to under $1 and may disintegrate altogether as coalition is too fractious

UK is a bigger version of iceland; the $4.4T of foreign liabilities its banks have accumulated are twice the size of the whole economy; there will be a run on the pound as the ability of her majesty's govt to repay all the financial obligations it has taken on will be seriously doubted

Asia's export-dependent economy is a mess; emerging economies were most vulnerable to reversal of the global liquidity pump

Chinese estimates of unemployed migrants (heading back to rural homes or otherwise migrating looking for work) is now over 23 million

social unrest we've seen in Athens and Riga and London and Paris and Kiev will go global and will be particularly worrisome in China

China is the world’s largest surplus country just as the US was in 1930 and is at as much risk as anyone because it doesn't have internal demand to support the jobs, much less the job growth, its vast population has become accustomed to and is losing access to much of the external demand that was the raison d'etre for much of its economy; Chinese leadership may get desperate if conditions continue to deteriorate, and the only potentially effective measure it could conceivably resort to would be massive devaluation of the yuan (like it did in 1993, by 33%), which would be akin to Smoot-Hawley II

Baltic dry falling again, 27% down from March 10 and 85% down from 2008 peak --> oil will fall back to $40 if not $30

Nominal GDP will fall – everywhere; increases in GDP have been fueled by increases in debt, with the marginal efficiency of that debt increase falling over time so that more and more dollars of debt were required to fuel a single dollar of GDP growth (the ratio was about 2:1 from the 50s to the 80s but climbed to 6:1 in the last decade); in other words, the economy has been leveraged; now in deleveraging, the economy will be lucky not to shrink persistently as debt is repaid

Corporate profit impairment is not just a financial phenomenon - Q4/08 was supposed to be a great quarter for earnings due to easy YoY comps but instead had negative earnings, the worst quarter ever on record; now the non-financials will increasingly have their turn

profits are cyclically much more volatile than the economy (b/c they're basically leveraged off economic growth), but much more volatile than stock prices; earnings will fall as much as to 1999 levels

normalized earnings (accounting for the trumped-up nature of earnings and abnormal profit margins from the last decade due to excessive financialization and leverage) seem to be about $40-$50; peak earnings were a fantasy and may not be revisited for decades; assigning an average multiple of 15 would imply fair value in range of 600-750; but in this environment of deleveraging and huge uncertainty, it seems reasonable to demand a greater risk premium now than in a normal environment; in past periods of economic distress, single digit multiples have been common; assuming a multiple of 10, fair value would be 400-500

S&P has not yet bottomed - will fall below 600 in H2; Dow 5000 would not surprise me; TSX 6660 as lows

Fed BoC BoE BoJ SNB BoI will be joined by ECB with a 0 handle and in QE; no hikes until late 2010 and no normalization of rates before 2011 at earliest

Competitive currency devaluation will lead to more obvious beggar-thy-neighbour strategies than those already in play; global trade, already getting slaughtered, will be more at risk as protectionism is already on the rise

It took WWII to pull the world finally out of depression - chinese military aggression, perhaps in siberia, would not surprise me as china clearly even in a slow economy has a large appetite for real assets, and will have the opportunity to take advantage of a very economically-weak but resource-rich neighbour while giving its unstable civilian population something to think about other than overthrowing the govt

FORECAST - year-end 2009:
Universe Bond index: 8%
Long Bond index: 14%
S&P/TSX: 6500 (-28%)
S&P 500: 600 (-33%)
BoC & Fed: 0%
C$: 0.79 USD/CAD
oil: US$35
U.S. recession duration: 72 months before GDP returns to previous peak
(may include double-, triple-dips; Japan-like)
In one word, what will turn U.S. economy around? Normalization (of debt-to-income, home prices (price-to-rent, price-to-income), banking as proportion of economy, global imbalances, income inequality)