The Coming "Y-Shaped" Depression

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drbubb
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The Coming "Y-Shaped" Depression

The Coming "Y-shaped" Depression

A Greater Depression is already "Baked in the Cake"

===========================================

(I thought this new article might be of interest to some here. It was published about a day and a half ago on Financial Sense, and has been picked up all over the web.)

I have been asked by many on my Global Edge Investors Website to explain why I am "so surprisingly bearish" about the prospects for 2010 and beyond. My opinion is that a Depression is already "baked in the cake", and we will soon be "eating the cooking". The best we can hope for is to delay the inevitable, and/or to make a very severe recession or depression as quick and painless as possible. Recent actions by political leadership and monetary authorities in the US and the UK have delayed the most severe part of the recession. But the cost has been high, and the eventual downturn may be worse than if they had taken different actions or simply done nothing.

 : A "Y-shaped" downturn?

There is much talk of a possible "W" shaped, or double-dip recession. What is being little discussed is what I call a "Y" shaped downturn, where the second fall is so severe that it dwarfs the first dip, so that the second leg down comes to a lower level. When the two economic falls are put together the resulting pattern may look more like a small-case Y than a W. And the upturn may be slow in coming, with no quick recovery coming out of the second slide. The overall result may be worse than the 1930's, a Greater depression, rather than merely a repeat of what we saw eight decades ago.

George Soros recently spoke about a recovery that looks like an "inverted square root sign." In other words, growth stalls, and the economy goes sideways for some years. "We may even see another dip, if stimulus is not maintained," he said. Frankly, this confuses me. The economy has been hampered by wasteful investments, and too much debt. The so-called "stimulus" plans add debt, and encourage more low-return or no-return investments. I do not see how these programs help the economy. Many of the best known economists are already talking about a recovery which they say is underway. Indeed, the US has just reported Q4.2009 economic growth in excess of 5%. On my own GEI website, I have been accused by one poster of "drifting off into neverland talking about what to do after a financial holocaust which has not happened yet."

Why am I expecting a new, more severe downturn?

My expectation is that the next economic downturn will come quickly starting about mid-year, and those who fail to prepare will be blindsided, and suffer a very large loss of wealth. The time to make preparations is when confidence is high, and the cost of preparations is low, because fear has receeded. After a strong nine months rally in global stocks (which by the way, I forecast back in March as the market was turning up), there is now widespread denial of problems, and huge complacency. Preparations can be made now, and hedges put in place, at a low and bearable cost.

The basic problem that I see is two-fold: Too much debt, and widespread malinvestments. There is no longer a reasonable balance between the funds needed to service the debts and the cash flows generated by investments. The severity of the problem is masked, but only temporarily, by ultra-low interest rates. Even with the low rates, debts are continuing to default, and the number of troubled loans is increasing. When the inevitable rise in rates comes without a big rebound in earnings and cash flow, debt problems will multiply, and the financial sector will seize up with another severe credit crisis.

Here is an outline of my overall argument:

+ A second leg down in US house prices lies dead ahead, with even larger fall is possible in the UK

+ Commerical property is headed towards a debacle in both the US & the UK

+ A second banking crisis seems inevitable (as the above problems manifest themselves)

+ Sovereign and US state credit ratings have come into question, and defaults are likely in 2010

+ Days of low inflation from the first downturn are ending (as low inflation from early 2009 gets lost in history)

+ Rates are bound to go higher, as savings rich countries attempt to flee the increasing credit problems

+ Iceland, and its stagflation are a model for the future in many countries, including the US & the UK

+ Weaker currencies are not really a cure, since they will bring much cost-push inflation in food & energy

+ The longer term cure only begins after we face reality, make writedowns, and restructure the economy

+ So-called stimulus programs merely add debt, and low-return investments to an economy which needs better More specific remedies:

+ New types of investment are required, western consumer economies must be restructured towards becoming producers again with more internal savings. That is a slow process, especially when limited capital is being steered towards wasteful areas, propping up old malinvestments in a an obsolete consumer-driven economy, rather than aiming to build a new and more efficient post-consumer economy with dramatically less reliance on expensive imported energy

+ As savings are rebuilt in Western countries, growth will be slower, and probably bring negative growth for many years. + Those who are unprepared and unhedged are likely to suffer a huge loss in their wealth

(Related charts); in posts#2-4: here

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drbubb
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Re: The Coming "Y-Shaped" Depression

HOW THE CRISIS MAY PLAY OUT*

The big drop in oil and commodity prices and massive deleveraging beginning in the second half of 2008, brought several months of negative inflation numbers. Most observers focus on 12 month's CPI inflation, and so these price drops gave central banks the cover that they needed to sharply reduce interest rates in late 2008 and early 2009. Starting with the UK, we saw massive quantitative easing (QE) programs in many Western countries, which brought rates down to levels which enabled falling asset prices to stabilise and rebound.

The Temporary drop in Inflation is behind us In virtually all countries, the months with the lowest CPI in most countries were in Q4-2008 and Q1-2009. Those low inflation months are falling out of the 12 months window as we move into 2010. In Q2-2010 we will find that many countries will be soon be reporting "higher than expected" inflation. If people looked at the data closely, they would not be surprised to see 12 months inflation rates rising in the months to come, but many do not bother to check the details. But even those that do investigate and anticipate rising inflation, will have to admit that inflation has pushed up above normal "target" levels, which for most Western countries is set at 2% or so.

The rising inflation is unlikely to be accompanied by healthy and sustainable growth. There will be growth in most countries, but much of this will be merely the result of debt-fueled government stimulus spending. Plus there will be some temporary factors like 1 million temporary jobs being added in the US to assist with the 2010 census. Businesses have be reluctant to spend and rehire, because they do not trust economic growth which is so heavily reliant of the false elixir of govern stimulus. The Fed and other Central banks will soon be caught "between a rock and a hard place," seeing that it is prudent to raise rates, but not wanting to do so for fear of pushing unacceptable unemployment levels even higher.

The UK and countries in Europe may feel stagflation acutely, since productivity in those countries has not improved as sharply as it has in the US. But if they keep interest rates low, their currencies are likely to get hit by selling. That may help exports to some degree, but it will come at the cost of more cost-push inflation from higher import prices. Europe will also feel the stresses from deterioration of sovereign credit rates, as countries like Greece, Spain, and Ireland are pushed into defaults or painful bailouts. The US will face similar challenges from the continuing rapid deterioration of the financial condition of most US states, with California a particular concern.

US & UK property prices - the Rallies will soon stall .

(Source: US Case-Shiller Index-20 Cities x1,300; and UK: Average of Halifax & Nationwide prices, NSA)

I expect that the property rallies in the US, the UK, and most other countries will be over with prices falling again by the end of the first quarter of 2010. The UK property cycle peaked in Q3-2007 and has lagged more than a year behind the US cycle, which peaked in mid-2006. By the time that QE was working, and ultra-low interest rates began to stabilise assets in late Q1-2009, property prices had fallen only about 20% from the peak in the UK versus a drop of about 33% in the US. Ultimately, I could see both markets falling 40-50% from peak prices, and perhaps more, based on a return to more normal ratios of property prices to income level. If I am right about this, then the UK property has a much further distance to fall from current levels than it does in the US. Sliding property collateral values are likely to cause big problems for banks in both countries over the next 2-3 years.

Ultra-low Interest Rates - How can rates stay down when Inflation is rising again?

For many years, Central Banks kept their interest rates above the Inflation rate. Then, in 2001, in reaction to the panic caused by the 9/11 incident, Greenspan brought down US rates so that 3 months Libor was below the 12 months CPI. To prevent a recession, which would have had a healthy cleansing effect on the economy, he held rates down at zero real interest rates for about two years. That was the beginning of the big trouble for US property. Low rates touched off a speculative boom in property, which became a global phenomenom. As home prices rose, people thought they were getting more wealthy. Banks accommodated the expansive mood, by lending aggressively refi loans and home equity loans. Feeling flush, people began spending more aggressively, and reduced their savings to near zero.

The spending and borrowing boom brought many years of high growth, but it was not healthy and sustainable growth, since it was predicated upon easy money. To return to a sensible balance between debt and income, debts will need to be reduced, and malinvestments written down and restructured. Essentially, the US and the UK spent more than 7 years of income in 6 years, and they will now need to spend less than 6 years of income over 7 years or more in order to unwind the excesses. (A simple calculation will show that a shift from 7/6 to 6/7 is a drop of 26.6% in spending.) Such a severe downshift in spending will mean many jobs in sectors like retailing and consumer finance will be lost as spending is cut back. And banks and other institutions that financed the inflated asset values will need to writedown their loans to what is collectible from reduced cash flows. 12 Months CPI is again on the rise in both the US and the UK...

Month : CPI-US : 3mos :12mos / CPI-UK : 3mos :12mo

Sep09: 215.97 : 0.51%:-1.29% / 111.5 : 1.80%: 1.09%

Oct.09: 216.18 : 1.53%:-0.18% / 111.7 : 2.89%: 1.55%

Nov09: 216.33 : 0.92%: 1.84% / 112.0 : 2.15%: 1.91%

Dec09: 215.95 :-0.04%: 2.72% / 112.6 : 3.95%: 2.83%

Inflation in the UK is especially problematic, as the weak currency has spilled over into cost-push inflation from rising import prices. The 12 months CPI rate is likely to push up to 3% above in the first quarter of 2010. The exceeding of the 2% inflation maximum target will require the BofE governor to send a letter to the Chancellor, and this may require a rethink of Britain's ultra-low rate policy. The UK's zero interest rate "prop job" may have slightly improved Labour's remote chances of being re-elected in 2010, but the rally has had the perverse effect of bringing confidence back to an overvalued market, and encouraging additional highly geared home purchases, some doubtful lending, and more malinvestment in property. If I am right, that the UK has still a long way to fall, then the house price bounce we saw in the UK in 2009. will have served to delay the downturn and make it deeper. The impact on the banking sector will be to deepen the losses suffered by banks, and bring more long term headaches for the UK taxpayer.

A Second US Housing bust?

 

Meantime, in the US, a second wave of mortgage loan troubles is coming as Alt-A and Prime rate loans reset, from artificially low levels. We can expect to see the 7 million US mortgages presently in default leading to more distressed residential real estate sales, and more downwards pressure on property prices. Commercial real estate in both countries is going to be falling, and that will add additional problems for the banks, and threat to economic growth.

It is impossible to imagine that consumers in the US, the UK and Europe will find they are able to resume the freespending ways of 2005-7 when they could still easily borrow against rising home values. In 2010-13, they will be getting hit with the bill from the lavish years, through increased taxes and the loss of millions of jobs. Economies which became excessively consumer-oriented are going to be forced to slim down. Meantime, governments have been reluctant to tighten their belts, and are trying to restore "the old normal", by borrowing money aggressively, and spending it recklessly on poorly-designed stimulus programs.

The foreign holders of dollar, sterling, and euro debts, will try to get the taxpayers to foot the bills for the excesses of their banks and the governments. But there is an increasing risk that taxpayers will revolt, and refuse to pay the full amount of those debts. We have already seen a rejection like this already in Iceland, and it seems this sort of drama will soon be played out in Greece, and the other PIGS countries in Europe, and also in many American states. Eventually, the larger economies of the UK and the US may also face the same problems, when debtors begin to reject lending fresh money to over-stretched sovereign borrowers.

Icelandic Inflation

Iceland has shown how this can play out. If confidence is lost, the currency slides and inflation jumps as the price of essential imports rises. At some stage, rates are forced higher (to protect a weak currency) and a country in this situation finds itself in a stagflationary trap. Stagflation is an enemy to stock prices, so if we see this pattern, we are likely to see deep falls in most global stock markets in 2010, 2011, and possibly into 2012. For the US, I expect to see the March 2009 lows of SPX-666 retested within 18 months.

When taxpayers revolt, and banks and governments are forced to default on their debts, then credit markets freeze up, even for sovereign borrowers. I believe that the crisis is likely to spread until some time in 2010 or 2011 when even the UK and US governments will have trouble borrowing. The drama may play out like a game of musical chairs, where as one country defaults, then money flows into the smaller number of countries whose currencies still appear to be sound. More and more chairs may be pulled away until only a few countries are left standing. I believe that the US and the Dollar may stand up longer than several other countries, especially those in Europe. So the perverse effect may be that the Dollar strengthens, despite fundamentals that are not great. Bob Prechter may think that the US may be one of the last currencies left standing. The current consensus would be that the safe havens will be Gold and the Chinese Rmb. I would agree with that, but there is some possibility that it may not play out that way, particularly if China held onto its dollar assets, while selling down its other investments. But I regard this as an interesting long shot, rather than a high probability.

Once a country defaults, it will be likely to face the fate of Iceland. Defaulting countries will have to generate more of their savings internally, since foreigners will be reluctant to lend to them. This will bring higher interest rates, and a severe "stress test" on any business that uses debt. Stock prices will plummet, and weak businesses will be forced to the wall. The US lived through a 1-2 year period like that in the mid-seventies. But the cash flow stress is likely to be even more severe and more long lasting in the years to come. The vulnerability is high, because the US and UK are much more dependent now on foreign sources of capital.

__ __ __

*My scenario is only one of many. Shared characteristics of the ones that I find most plausible are: a drop in the currencies of Western debtor countries, higher interest rates, and a need to replace the flows of cheap capital from Far Eastern savings countries with more internally-generated savings within Western countries. The days of wasteful consumer-oriented economies may be numbered.

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docmims
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Re: The Coming "Y-Shaped" Depression

Well yes, but I think there will be a bottom.  It may take up to a decade  to revamp our factory production and farm output, but the US still has vast natural resources and farmlands that are idle, because we are trading worthless paper and data bytes for other countries'  resources. I am sure the Ponzi game will end fairly soon and wall streeters and bankers will have to get a "real" job.

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drbubb
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Re: The Coming "Y-Shaped" Depression

It will niot be easy to restructure, restart, and rebuild with such depleted capital.

The fact is Americans have become enormously wasteful over the past 2-3 decades, and it will take time to learn new habits, and beginning living differently so we waste less, and regenerate our wealth.  I am sure you know there are many ingrained ideas and attitudes that prevent the change.  You should not underestimate how powerful the forces of denial and complacency are; especially when "someone else" is doing the suffering.

If your optimistic attitude was so easily justified, wouldnt we have seen more positive changes sooner?

We must expect the worst from our sleepwalking fellow citizens, be realistic, and work hard for the change

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docmims
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Re: The Coming "Y-Shaped" Depression
drbubb wrote:

It will niot be easy to restructure, restart, and rebuild with such depleted capital.

The fact is Americans have become enormously wasteful over the past 2-3 decades, and it will take time to learn new habits, and beginning living differently so we waste less, and regenerate our wealth.  I am sure you know there are many ingrained ideas and attitudes that prevent the change.  You should not underestimate how powerful the forces of denial and complacency are; especially when "someone else" is doing the suffering.

If your optimistic attitude was so easily justified, wouldnt we have seen more positive changes sooner?

We must expect the worst from our sleepwalking fellow citizens, be realistic, and work hard for the change

You are right on the above, however it will take a crash to change things then people will do what they have to.  It will take a kick in the ass to get started, but I think we'll do it.

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drbubb
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Re: The Coming "Y-Shaped" Depression

You are probably correct.

But the time people are frightened enough to want to do something, prices will be much different than today.

The opportunity to adjust your portfolio is now, while complacency reigns, and prices are high

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drbubb
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Re: The Coming "Y-Shaped" Depression

[quote name='DrBubb' date='Feb 8 2010, 12:30 AM' post='155905']
[b]My opinion is that a Depression is already "baked in the cake", and we will soon be "eating the cooking".[/b]
+ Commerical property is headed towards a debacle in both the US & the UK
+ A second banking crisis seems inevitable (as the above problems manifest themselves)

The most serious wave of commercial real estate difficulties is just now beginning’
Quote
Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present ―underwater– that is, the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates, which now range from eight percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.

Quote
The largest commercial real estate loan losses are projected for 2011 and beyond; losses at banks alone could range as high as $200-$300 billion. The stress tests conducted last year for 19 major financial institutions examined their capital reserves only through the end of 2010. Even more significantly, small and mid-sized banks were never subjected to any exercise comparable to the stress tests, despite the fact that small and mid-sized banks are proportionately even more exposed than their larger counterparts to commercial real estate loan losses.

/source: http://www.housepricecrash.co.uk/forum/index.php?showtopic=136796

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