"Low-probability" events that I currently predict:
- U.S. is experiencing a balance sheet recession, much like the Japanese did, which leads to very different outcomes than do typical inventory-led recessions, meaning that this will be a bump-along, virtually no-growth era, albeit with lots of volatility
- the wide output gap will persist; economic slack will continue to be disinflationary
- U.S. housing STILL has not bottomed; houses remain overvalued and with the excess supply of homes, even ignoring shadow inventory, (months supply of existing homes now at 12.5 months), pressure on prices will resume
- the U.S. household balance sheet continues to have very much more debt than can be serviced given incomes and nonexistent income growth (median household income adjusted for inflation has not grown since 1997); there will be many more write-offs, loan loss provisions need to increase, which will hit earnings, and deleveraging will persist for a LONG time
- as households delever, deflation picks up (deflation is the contraction of money and credit; though prices as calculated in the CPI are not yet falling, M3 IS, thus deflation)
- with excess capacity and no demand growth, there's no impetus for production growth (other than very short-term inventory cycles), so there is no impetus for employment growth
- waning of inventory rebound and of federal fiscal stimulus will not just no longer add to growth, but will detract from growth, as will the state & local budget cut-backs
- if the U.S. does not double-dip, it will only be because the NBER decides the recession starting December 2007 hasn't actually ended yet (a mid-recession bounce off the lows that does not reclaim the old peak before the down-trend resumes may not justify an end-of-recession call)
- Canada will not decouple from the U.S. going forward any more than it did in 2008/09
- Canada has its own internal imbalances (consumer credit, household debt, housing activity & prices) which makes it not just vulnerable via external shocks, but vulnerable too to unsustainable domestic demand
- China does not just contribute to global imbalances, but has its own severe internal imbalances, which are unsustainable and thus won't be sustained, and China will suffer the same fate as Japan in the 1990s and the U.S. now in the aftermath of the crash of an asset bubble (though many believe the Chinese government has plenty of ability to fine-tune the economy and keep growth near double-digit range, there is not much precedent for successful central planning economies)
- stocks remain in a secular bear market, despite the cyclical swings; stocks will fall below 800 as current very rich valuations (based on cyclically-adjusted P/E ratio and Q-ratio, as opposed to forward P/E) are predicated on robust earnings growth due to robust economic growth, neither of which will materialize; in fact, if fair value is 850ish, and given that stock markets always over-react in each direction, a revisiting of the 600s is not out of the question
- investors will shun stocks and continue to restock the fixed income holdings on their balance sheets, which, for households, remain very low, particulary given the aging baby boomer demographic situation
- Fed will be on hold at least until 2014, likely longer
- BoC will get its overnight rate no higher than 1% while Fed remains at 0%, and I believe it will cut rates again once the shxt hxts the fan again (i.e. once the fact that there's no recovery to speak of becomes obvious)
- the secular bull market in bonds that began in the 1980s has not been broken yet and will not be in the next few years; bond yields will break through the 2009 lows, getting closer to Japanese levels in 2011; US10s will get below 2%, Canada 10s under 2.5% and long bonds to 3%
Context: "Low probability" events that I have previously predicted:
- in late 2006, anticipated not just U.S. housing stalling, but crashing; a recession in 2007; an S&L-type financial crisis
- in Q1/2007, I thought the economy would be in recession in Q2, if it was not already (wrong; but it was by the end of the year)
- in Q2/2007, I predicted a Minsky moment, that the debt bubble would burst (and though I sold most of my non-bank ABCP, I foolishly rationalized not selling my one last piece as it was just a 2-month maturity)
- and that the S&P would fall below 1000 (I was the only in-house predictor of negative stock returns in 2008; however, I was also the only predictor of negative stock returns for the rest of 2007, which was incorrect; early again, like with the recession)
- it was in Q3/2007 that I first started predicting that the U.S. would likely, due to a cratering asset bubble and large private sector debt burden, have an outlook similar to Japan in the 1990s
- in late 2007/early 2008, I predicted that the Fed would drop rates to the old low of 1%
- and, at that time, I believed it was too early to be buying credit (but I did not advocate for selling credit, and I certainly did not foresee spreads widening anywhere near as much as they ultimately did)
- in early 2008 I noted that economic growth since the 1980s had been driven by debt growth, with more and more debt required over time to buy each unit of GDP growth, and therefore that in the absence of debt growth there would be no economic growth; and that though the government could fill the void for awhile and offset private sector deleveraging for a time, it could not do so indefinitely, so economy-wide deleveraging would happen
- in 2008 I agreed that subprime was contained --- to planet Earth
- and I predicted, when losses so far were under $400 billion, that credit writedowns would easily exceed $1 trillion
- I also suggested in mid-2008 that the Fed was in a liquidity trap and that monetary policy, though easy, would not be effective (pushing on a string)
- in Sept 2008, when the S&P was at 1200, I expected stocks to go down a further 14% in 2008 and be down 8% in 2009 (down to 800 then up to 1000) (wrong -- they went lower than I anticipated (to 666), then recovered much more than I anticipated (to 1150))
- in late 2008 I predicted that global decoupling was an optimistic myth, that the global economy relied on the U.S. consumer and would be dragged down by it
- in 2008 and 2009 (and still in 2010) I believed that U.S. housing was not yet in a sustainable recovery
- in early 2009 I predicted that unemployment, then at 8.1%, would exceed 10%; I predicted that the Fed would be on hold for quite some time as, though an overnight rate of 0% seemed very accomodative, relative to a Taylor Rule approximation, it wasn't easy enough, and, because it NEEDED to be very easy, it would STAY very easy; I remained in the deflationary camp; that Fed's so-called printing of money through QE was ineffective as it wasn't a helicopter drop into the hands of consumers, but was instead sitting in banks' excess reserves (effectively just an asset swap), so though the Fed could expand the monetary base, as the money multiplier and velocity fell, monetary base expansion would have no effect on P*Q
- in spring 2009, I removed my hedges, assuming stocks would get back to 900 (at which point I started hedging part of my equity exposure again) or 1000 (at which point I became fully hedged); I did not expect the S&P to get above 1000, and did actually expect much lower stock prices in H2/2009 (below the March low --- wrong) (so I became net short equities as stocks got to 1100 and further at 1200)
- in Sept 2009 I predicted that the Universe bond index would return over 6% and the long index around 10% in 2010
- in late 2009, I predicted that bond yields would head higher in the first half of 2010, along with stock prices, as investors assumed the recovery was underway and entrenched, but that yields and stocks would fall in the second half of 2010 as it became obvious that the stimulus-induced and inventory-led recovery was temporary and not sustainable and that underlying demand remained anaemic and the recovery was really no recovery at all
in other words, just b/c a type of event in a normal economic environment might be of "low probability", in a different type of environment, all bets are off, and probabilities need to be significantly re-appraised
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