Saturday, November 1, 2008

Some Key Questions

The most important question facing us today, both in the US and around the world is just how much of our supposed wealth is real and how much was part of the illusion generated by bubble-mania and the UDB. Most of the actions of various governments and CBs seem aimed at preventing us from answering this question accurately. In The Limits of Optimism we outlined the various elements of the capital structure and it should be immediately apparent why the stock market is the chosen instrument for conjuring chimeras. By coercing a larger and larger percentage of accumulated capital into stocks, Wall Street ensured a large pool of buyers to continue pushing prices higher in complete defiance of fundamentals. By allowing so much of our wealth accumulation to be attached to something so insubstantial, we have collectively ensured the destruction of much of that wealth. Something that falls as soon as anyone wants to sell isn't much of an investment.

Now we see some of the real world impacts of aggressively tying ourselves to the stock market. Once again, the secondary feedback effects may be greater than the primary impact. According to the

At the end of 2007, companies in the S&P 500 had a combined pension-plan surplus of about $60 billion, The market selloff in the nine months to late September turned that into a combined deficit of about $75 billion...

Of course that was before October even started and we all know that things didn't go so well during that month either. Double digit declines were the rule for the month - pretty much across the board. The pension obligation and attempt to meet it by speculating in the stock market are yet another example of companies tying their fortunes directly to stock market whims rather than fundamental performance. It worked well for a while - allowing them to report higher profits than justified by actual results as speculative profits allowed them to pay less into the pension funds than a sensible and stable plan would have required. The reverse is now occurring and it's going to be nasty. This is yet ANOTHER headwind for corporate profits as they are forced to pay cash in to make up for speculative losses.

The lesson that should be learned here is "don't gamble with retirement money" but I fear few will choose to learn it until all other avenues have been exhausted. People can usually be counted on to do the right thing after all else fails.

Confirmed Reservations

Occasionally, I will encounter a supercilious restaurant host who will haughtily ask if we have reservations. When the right mood strikes the answer will sometimes be "yes, but we're planning on eating here anyway." In much the same vein, our prior reservations about the export economies and China in particular have been confirmed with a vengeance recently. Reuters reports that China's PMI hit 44.6 in October - indicating clear and serious contraction in factory output. This now makes three of the last four months down. In addition, recent BBC reports suggest that half of the toy factories in China have shut down since the start of the year.

Keep in mind that we expect a crash and burn in China's economy even if exports stagnate, much less roll over. Government action can partially ameliorate this but only to a small extent. We laid out the full case four months ago in China Syndrome. All of the elements preliminary requirements have now been met for this scenario to play out. The US is desperately trying to prevent a meltdown across the submerging markets with swap lines to exchange valuable dollars for garbage currencies like the Mexican Peso and the Brazilian Real. The temporary availability of dollars in those imploding economies has relieved the pressure from capital flight for the moment and perhaps even caused a small short squeeze for those who were looking for reality to catch up to those nations' financial system. But the banking systems overseas cannot sustain their credit expansion in the face of falling external demand and especially the collapse of primary commodity prices on which their economies rely heavily.


qadi said...

Credit will expand might fast once risk-free returns are assured.

War always works for this... as does Keynsian crap!

Bill said...

OT to your terrific post, but I figured that if anyone had an intelligent opinion on this it would be you! Just read this comment on Macro Man...

Bond market outlook.

MM,I have been trading Gov. bonds for 15 years and I never felt as puzzled as I am now about where 10 year yields are going. It seems very obvious that Gov. bonds yields should go higher because huge supply, lower tax revenues less petrodollars to be invested.

Real yields have moved higher but nominal yields still very low ... so what happens next? maybe inflation will fall so fast in the next 6 months that real yield will go up without nominal yields having to move much ... remeber Japan, nominal yields still < 1.50% in 10y while debt/GDP ratio exploded at the same level as Italy.

As far as supply is concerned, Gov. supply will more than double next year, in US,UK and most of Euroland but corporate supply has almost stopped ... and as long as it remains the case the net supply of duration to the market does not increase much ...

I know you have briefly touched on Gov't supply crowding out corporate issuance, but how likely is it that nominal long term US yields remain relatively stable while real yields increase because inflation has crossed the Rubicon?

golfblog said...

You think an Obama administration and Democrat Congress will try and inflate our way out of this? Or try and pass $10 Trillion spending bills?