It's been a few months since we last checked in with Gary Shilling [May 14, 2009: Gary Shilling's Latest Thoughts] so with all the green shootery going around, I thought it would be interesting to see if he is swaying. Much like myself, it seems not so much.
- Among economists, Gary Shilling owns one of the most prescient forecasting records, having accurately predicted the credit crisis and the performance of key asset classes over the last several years. Now, he says, the chances that the current wave of green shoots will be the finale to the recession are pretty low. Shilling delivered his latest forecasts when he spoke at the Forbes Advisor Conference last week.
- Of the 11 post-World War II recessions, eight of them had at least one quarter of GDP growth. Recessions are not a straight down affair, Shilling said. They go back and forth. Stocks follow the same pattern as the economy, he said, and bear market rallies are the norm, not the exception.
- Excess housing inventories will hinder recovery for at least a year. Due to the long period of overbuilding, housing inventories are approximately 2 million higher than normal. Excess inventories are the mortal enemy of prices, Shilling said. Hepredicted that more home equity will be wiped out, causing additional walk-aways and further problems for mortgage lenders. If nothing happens to get rid of housing inventories, it will be the end of 2010 before inventories are worked down, he said.
Sounds about right, remember housing started to crumble in 2006; our model for regional housing downturns is on average 6 years. 2006, 2007, 2008, 2009, 2010 gives us 5... so our national disaster in housing should be finishing up around 2011. I also believe that is the peak year for option ARMs to reset but by then we should be through at least 3 more rounds of banking handouts and home buyer incentive plans. And gearing up for Palin-Obama 2012!
- Although he suggested, in an op-ed piece in The Wall Street Journal, that excess inventories be sold to immigrants with H1 visas in return for permanent resident status, he conceded that anti-immigration sentiment would not allow it. Time is the only catalyst to reduce housing inventories.
- Housing prices are down 32% from their peak; Shilling forecasts a 37% decline but warned that it could overshoot. This is very debilitating and a strong depressant of consumer spending, he said.
Shilling said shoot! wait... not a green one, but an over one. Darn - thought we had converted him to snorting bull. Don't worry readers - I am looking for any 2nd derivative improvement in his wording; you know secretly all of us are bulls inside.
- Indeed, consumer retrenchment will impede economic recovery. Shilling recalled how consumers reduced their savings rates in the 1980s and 1990s, using their equity portfolios as a source of wealth, and then seamlessly shifted to borrowing against residential real estate. Now, the average individual with a mortgage and 50% equity at the market peak has seen his equity dwindle to 22% -- with a decline to the mid-teens likely to come.
- Consumers today have no alternative but to save, Shilling said, and as a result will spend less for goods and services.
That last point should sound VERY familiar to long time readers - those were exact words we were saying long ago... Americans won't WANT to change their behavior. They will be FORCED into savings. It has come to pass.
- Production cutbacks will result, causing layoffs and wage cuts, which in turn will lead to further cuts in spending. This is a vicious cycle that must be broken before we get out of this mess, Shilling said.
On to the stimulus aka Pelosi's Plan
- Fiscal stimuli are the logical solution, but Shilling is not satisfied with the efforts so far. In the first $787 billion package passed by Congress, he said, only $200 billion went toward true stimulus spending - infrastructure projects, increases inunemployment benefits, or tax cuts.
- The remainder went toward the Obama administration's social agenda, and will not lead to increased consumer spending.
Nailed that one on the head. But again, let's not worry - if we fail on Stimulus 1 (Bush), Stimulus 2 (Obama) there is always Stimulus 3.
Now for some of the more controversial items as the deflation v inflation debate rages on in economic circles (I admit to being a flip flopper on this one!)
- A byproduct of reduced spending will be deflation, which has been a consistent theme in Shilling's forecasts for the last decade. Declining commodity prices - led by decreases in the price of oil - and excess inventories will be the main drivers of deflation. Shilling said that, for the first time since the 1930s, employers have responded to the recession with wage cuts and shorter employee hours - instead of layoffs - and this, too, will fuel deflation.
So Shilling is in the Hugh Hendry camp here.
How do you invest in that world?
- Successful investing will hinge on positioning portfolios to defend against deflation.Traditionally, nominal bonds perform well in deflation, but Shilling warned that the rally in Treasury bonds is over.
- Instead, Shilling recommended focusing on sectors of the equity markets. Technology will be an interesting play, he said, especially among companies offering products to improve productivity. In deflation, companies cannot raise prices to increase profits, so they must reduce costs, he said, and productivity enhancing hardware and software does that.
- Another area Shilling recommended was consumer staples. If prices are coming down, consumers may cut or delay discretionary purchases like autos, cruises, appliances, and airline travel, he said. But staples must be purchased regardless of price.
- Shilling said to avoid companies with a lot of debt, as it will be more costly to service in a deflationary scenario. Consumers are already treating monthly payments on their own debt as discretionary, and Shilling advised against investing in the consumer finance industry.
- The U.S. dollar and Treasury bonds will retain their value and status as a safe haven, mostly because they are the best of a bad lot, Shilling said. The sell-off of Treasury bonds since March, when many who believed the recession was over increased their appetite for risk, was temporary. The dollar will recover, he said.
That last point is very unconventional to say the least - but Shilling had the same theory in the 1st half of 2008 when inflation was the raging thesis, and was proven incredibly correct in 2nd half 2008. If this happens again (dollar strong, Treasuries strong) it would go hand in hand with a very dark stock market in my view.
- Shilling warned that commodity currencies - those of New Zealand, Australia, and Canada - will be weak as dampened worldwide consumption levels will depress commodity prices. China is not going to buy up all the commodities in the world, he said.
Another completely unconvential view at this point versus the masses.
- The British pound will suffer because of the UK's oversized financial sector (15% of its economy, as opposed to 5% of the US economy). And the Euro has its own problems because of its one-size-fits-all structure, he said. Individual countries - especially Spain, Portugal, Ireland and Italy - cannot cut interest rates to deal with economic weakness. As a result, they must take on more debt, increasing the likelihood of ratings downgrades and that they will drop out of the ECU and go back to their own currencies.
On to China
- Investors should not worry about if or when China will stop buying U.S. Treasury debt; it will not happen, Shilling said, because the Chinese are not suicidal.
- If the Chinese moved away from investing in dollar-denominated assets, the U.S. currency would collapse and trigger a global Depression. The Chinese, whose economy is utterly dependent on exports, would be the big losers.
I agree with this... for now, as outlined in posts throughout 2008. A decade from now; different story.
- Now the Chinese want to export, but the U.S. does not want to import - and the U.S. wants to export as well.
Oh, a conundrum of the highest order.
- If everyone wants to export, the logical result will be protectionism. This will be very unfortunate and will lead to slower growth in the long run, Shilling said. Protectionism is a very real threat.
I agree here; one could postulate the US wants a weaker dollar (while talking up the strong dollar charade) because it sees its consumers are dead on arrival. So it needs exports, and weaker currency makes your goods cheaper to outside interests. One way to have a weak dollar is borrow like a drunken sailor (we've nailed that one) The problem is WHO IS GOING TO BUY everyone's exports. I guess the thesis is China will take all of Japan's, Europe's, and America's exports.
- Shilling expects the federal government to play a bigger, chronic role in preventing high unemployment, because politically it cannot afford to have the jobless rate rise year after year. He did not say what measures this chronic intervention would take.
- The recession's shape will be more like an L, Shilling said, with slow recovery and muted growth. I see nothing steep enough to suggest anything like a V-shaped recovery, he said.
Much of this will be familiar to FMMF readers - the only huge hinge play in all this remains deflation v inflation. I think both can occur in different parts of the economy. We are not in a vacuum, and global competition for commodities (a long term structural change) will continue to pressure prices upward, over time. With Americans weakening purchasing power, and wage increases - that's just another tough pill to swallow.
The dollar, and US bond strength is also very much an outlier - it will be interesting to see if Shilling was correct on this (again) if 2nd half 2009 bears any resemblance to 2nd half 2010.