John Mauldin- The Problem of the End Game

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John Mauldin- The Problem of the End Game
One Last Thought on the Trade Deficit
Broken Relationships
Party On, America!
China, California and a Few Details

By John Mauldin
January 14, 2005

Last week we looked at my 2005 Forecast. This week, we ponder the far more
interesting question of where I could (or will be!) be wrong and why and what
would be the consequences.

This week's topic came about as I was talking on Tuesday with Van Hoisington of
Hoisington Investment Management Company. He and Dr. Lacy Hunt had just
published their 2005 Forecast and I considered it quite thoughtful. I called to
ask if we could use it for next Monday's Outside the Box.

He had just read my forecast, and noted that we disagreed in a few areas. "That
is precisely," I noted, "why I want to use it. Outside the Box is supposed to be
about different ideas." While I think long term rates will go up, he and Hunt
think they will be essentially flat or maybe even drop. We talked about this and
some other scenarios, with both of us noting that we could be wrong on one thing
or another. "The really useful thing would be to know," I said, "where we are
going to be wrong."

Let's be clear about one thing: it is quite likely that one or more of my
predictions will be wrong, hopefully because I was not optimistic enough. As
Yogi Berra noted, "It's tough to make predictions, especially about the future."
In today's complex world, it is especially tough.

For quick review, let's look briefly at last week's musings. I called the
forecast "The See-Saw Economy" as it will take some precise balance and
coordination amongst all parties to continue the game. (You can read the
forecast issue at www.2000wave.com.)

I think the economy is likely to grow around 3%, a little below consensus. I
think long term interest rates rise, and the Fed increases rates more than most
think, topping 4% before the end of the year, barring the beginning of an
economic slowdown. Short rates rise faster than long rates, thus we see the
yield curve flatten. Since the US and world economy should continue to expand
nicely, demand for oil should increase or stay steady. Plus, OPEC really likes
high oil prices, and running up to $50 did not do any material harm to their
customers. Oil will go sideways in a volatile trading range with an average in
the low to mid-$40's, but with the surprise to the upside.

I do not like the stock market in a rising interest rate and/or rising inflation
environment. If we get both in the first half of the year, I really do not like
stocks, but I tend to see another trading range year like last year, but this
time with the pressure to the downside. (Along with my usual caveat that when a
recession appears on the horizon, the market will start to materially slump. We
just do not know when that will be - read more below.)

The dollar should bounce in the first part of the year until we can get some
more dollar bulls, or at least wash out the bears, and then the dollar resumes
it slide. Gold will do the inverse of the dollar. The trade deficit gets worse
in the first part of the year. I wrote:

One Last Thought on the Trade Deficit

"A falling dollar will not be enough to cure the trade deficit. It will also
take a rising savings rate from the consumer. What will bring that about? When
the next recession comes in 2006 or 2007, the stock market will drop. Average
drops during a recession are 43%. The Baby Boomer generation will realize that
the stock market is not going to bail out their retirement hopes. They will stop
spending and start saving with a vengeance. Problem solved, only it creates more
problems. The world will not like it when the American consumer retrenches.

"Since the bond market usually anticipates the actual recession, which means
that long term bond rates will fall, we should see an inverted yield curve prior
to a recession. Major caveat: with Fed manipulation and foreign central bank
buying, we are in new territory. The old rules may no longer apply, or be
applied differently. Pay attention, gentle reader. This is one we will watch
closely.

"As far as the end game, the short version is that once the recession starts,
the Fed moves aggressively to stimulate the economy, brings back inflation and
we get high rates and inflation. Over time, we end up in stagflation. Of course,
we will hit the reset button, work our way through that and start the next big
bull move. But all that is in our future. For 2005, we can enjoy the see-saw,
and hope our partners don't jump off."

Let me note that I assume that no one would act on these predictions and then go
away for the next 12 months. That would be the height of foolishness, as the
facts will change. And as Keynes famously noted, "When the facts change, I
change my mind. What do you do, sir?"So, where do I see risk in whether or not
these predictions turn out to be true? I look to the West - across the Pacific -
to Asia.

One of my principles for staring into the future is that in the absence of some
new contrarian fact, history should serve as a guide. Looking at history, when
the Fed raises rates at the short end, the long end more or less follows, rising
along with the short rates.

It did not happen last year except at the shorter end of the yield curve. And
this is puzzling. Short term rates rose 1.25%. The 2-year treasury rose from
1.88% to 3.1% and the 5-year note yields rose mildly from 3.28% to 3.6%.

But the ten year note behaved oddly. It started the year at 4.30% and ended the
year flat at 4.28%, but rose to 4.80% by June 11, about the time the Fed started
raising rates. It then proceeded to drop over 50 basis points from that point,
while (again) short term rtes rose 1.25%. The 30 year (or longest dated bonds)
dropped 0.25%. The usual reason given is that while foreign private investors in
general have shunned US investments, foreign central banks (read Asia,
especially Japan) are buying our treasuries in massive amounts.

History and other factors suggest to me that long term rates should rise as the
Fed raises rates. I still believe so, but here is the ##### in my forecasting
armor.

Broken Relationships

Let's start with this note from the January 14 essay by Stephen Roach, (Chief
Economist of Morgan Stanley). This is a partial quote. (You can read it in its
entirety at http://www.morganstanley.com/GEFdata/digests/latest-digest.html by
going to the archives.)

"...The diminished sensitivity of the US economy to currency fluctuations has
been increasingly evident over the past 15 years. Normally, a weakening currency
results in a narrowing of a nation's current account deficit and a pick-up in
inflation. That's pretty much what happened in the 1970s and especially in the
late 1980s in the aftermath of the dollar's sharp downward adjustment during
most of that latter period. But then it all seemed to change in the 1990s. The
dollar's decline in the first half of that decade was accompanied by a shift in
the current account from surplus back to deficit. And inflation barely budged. A
similar outcome has been evident in the past three years -- a 16% decline in the
broad dollar index (in real terms) accompanied by an ever-widening current-
account deficit and persistently low inflation.

"It's not altogether clear why this relationship has broken down. My suspicion
is that globalization is the main culprit. The globalization of supply chains
biases import content to the upside for the high-cost developed world; it also
forces the advanced economies to abdicate price setting at the margin to low-
cost producers in the developing world. The result is a sharply diminished
industrial base in countries like the United States. Manufacturing employment
currently stands at only about 13% of America's private nonfarm workforce --
down sharply from the nearly 23% share that prevailed in the mid- 1980s, the
last time the dollar entered a serious correction. Moreover, value- added in the
US manufacturing sector fell to only about 14% in 1993 -- down from 20% in 1985.
The sharply diminished size of America's industrial base makes it exceedingly
difficult for the US to turn dollar depreciation into an advantage and trade its
way out of a severe current-account problem through enhanced export growth and
import substitution.

"Nevertheless, the global rebalancing construct that I endorse still assigns an
important role to a realignment of major foreign exchange rates. In my view, a
lopsided world economy needs a shift in relative prices in order to establish a
new and more balanced equilibrium. Currencies are nothing more than relative
prices, essentially comparing the fundamentals of one economy versus another.
With the dollar the dominant relative price in the world today, a depreciation
of the greenback is necessary for global rebalancing. And, based on current
account adjustments of the past, there's good reason to believe that the broad
dollar index has a good deal more to go on the downside. However, due to
America's reduced currency elasticities [the relationship he spoke of earlier -
JM], a weaker dollar no longer appears to be a sufficient condition to complete
the global rebalancing process.

"If a weaker dollar can't do the trick, what can? The answer, in my view, is
real interest rates -- the price adjustment that could well qualify as the
sufficient condition for America's role in global rebalancing. The only way
America can ever get a handle on its trade and current account conundrum is on
the import side of the equation. After all, imports are currently 52% larger
than exports (in real terms), making it almost mathematically impossible for the
US to export its way out of its trade deficit.

"Given the asset-dependent character of US domestic demand growth, the interest
rate connection becomes all the more critical as an instrument of rebalancing.
Higher real interest rates will not only curtail the pace of asset appreciation
but will also raise the cost of debt service -- thereby exerting twin pressures
on the asset-driven portion of domestic demand. Needless to say, the saving-
short, overly-indebted, and asset-dependent American consumer should feel the
impacts of such an adjustment most acutely. But homebuilding will also be hit,
as will business capital spending to a more limited extent.

"So far, interest rates haven't budged nearly enough to spark a meaningful
rebalancing of a lopsided world. I suspect that the Federal Reserve is about to
lead the way in changing that...."

What Roach did not say (and perhaps does not mean) is that such events -
homebuilding down, increased cost of debt service, flat or dropping home values
- are likely to produce a recession. As I noted last week and again above, I
think it will take a rising savings rate from the American consumer to really
dent the trade deficit. I do not think that happens until Baby Boomers and those
in their 40's see a serious stock market decline coupled with a decline in
housing values. They then realize they will not be able to rely solely upon
growth in their 401k stock portfolios and double digit growth in home values to
get them to retirement nirvana. It is going to require savings and more savings.

Of course, the world and especially Asia will not like that. It will subject
them to a recession as well, or at least a glut of capacity.

As an aside, let me pose an odd question. I think the dollar will weaken, as
does Roach, and think it is necessary. But I don't run an Asian central bank.
What if we do see a global slowdown as a result of the US consumer retrenching?
Would it be so far out of character for some Asian nations to work to lower
their currencies against a weak dollar? Could we see a recession and a rising
dollar? When there is nobody in the central bank school yard, it is not
altogether certain that the "kids" will play nice in the sandbox. Just a
thought.

Party On, America!

Before we get to the real conundrum, let's jump to another essay released today
by Paul McCulley of PIMCO. (www.pimco.com) I think it is one of his more
insightful ones. I highly suggest you read it. Jumping to the middle:

"...Which brings us to Macroeconomics 104, where we learn that private foreign
net investment in America is putatively a good thing, while a large share of
foreign official investment flows in America's capital surplus is ostensibly a
bad thing. Why?

"Foreign private investors in America are theoretically profit-maximizers and
are coming to America to make profits, which is a sign that investment in
America must be more profitable than in other places.

"In contrast, foreign official investors in America are not profit maximizers,
and are lending America money as an act of mercantilist self interest, so as to
keep their own currencies undervalued, thereby giving their exporters an
"unfair" advantage against American producers.

"Accordingly, we also learn that the greater the official share of America's
capital account surplus, the more unsustainable it is, and therefore, the more
unsustainable America's current account (or trade) deficit is. Why?

"Since foreign official investors are not profit maximizers, there is no
assurance they will continue to lend America dollars if and when their non-
profit motives change, generating a disorderly decline in the dollar and dollar-
denominated asset prices and, therefore, a dark winter for the American economy.

"Now, finally, we have the theoretical prerequisites to register for the Senior
Seminar, in which we try to apply what we have learned to the real world. And
the first thing we learn is that the real world is a lot messier than the
textbook world!

"In present circumstances, the Fed's dilemma is either to: (1) downgrade, if not
reject, its mandate to foster full employment in America, or (2) pursue that
mandate with the virtual certainty of an ever-larger U.S. current account
deficit, exposing America to the risk that foreign official investors suddenly
decide, for their own non-profit maximizing (political?) reasons, to let a
plunging dollar plunge America into a recession (depression?).

"Which, of course, would result in the antithesis of the Fed's mandate to foster
full employment in America.

"So far, the Fed has chosen to honor its duty to pursue full employment in
America, underwriting the risk - repeat, risk! - that foreign official financing
of America's current account deficit becomes less agreeable. I firmly - very
firmly! - believe the Fed has made the right choice, even as I respect others
that feel differently.

"I do not view foreign official investors in America as either strangers or
acting out of kindness, but rather people we know who are acting in their own
national interest: doing the only thing they can do to support their job
creation, unless and until they discover the joys of more robust domestic demand
growth.

"In contrast, I've long worried - much more than most! - about a different risk
arising from current global circumstances, in which America must party in order
for the world's party staff to find employment: the risk of asset price bubbles,
which ineluctably become asset price busts.

"Indeed, I've long believed that asset price bubbles are not just a risk, but
also a virtual certainty stemming from current global circumstances."

He then goes on to note what virtually every Fed watcher has written about since
the release of the December 14 Federal meeting (I commented on it last week):
various members of the Fed are clearly worried about a number of things. Lack of
savings, lack of foreign consumption, potential inflation, trade deficits, US
government deficits and so on.

But let me again quote the real eye-opener from the minutes:

"Some participants believed that the prolonged period of policy accommodation
had generated a significant degree of liquidity that might be contributing to
signs of potentially excessive risk-taking in financial markets evidenced by
quite narrow credit spreads, a pickup in initial public offerings, an upturn in
mergers and acquisition activity, and anecdotal reports that speculative demands
were becoming apparent in the markets for single-family homes and condominiums."

In the past week or so, I count no less than three Fed governors in major
speeches who have said that there is no commitment by the Fed to only raise
rates at a measured pace of 25 basis points. Coincidence? After reading those
minutes, I would highly doubt it.

You think there wasn't some talk at the bar late at night during the meeting?
Three Fed governors on their own decided to talk about the risks to a "measured
pace" of rate increases within one week of each other? At least a few parties
felt the need to give the markets a heads up.

Couple that with Alan Greenspan's warning last November (after the election) in
Frankfurt: "Rising interest rates have been advertised for so long and in so
many places that anyone who has not appropriately hedged this position by now
obviously is desirous of losing money." I think it is pretty clear. Not only
does the Fed intend to keep raising rates, but they are hinting at the
possibility of a faster rate of increase than 25 basis points per meeting.

Going back to McCulley for a few more thoughts (as he says it much more clearly
than I). Noting he hoped he was wrong in his assessment:

"But hope is a poor excuse for an insurance policy. And when central bankers
start musing publicly about asset price inflation (risk premium deflation),
asset managers need insurance!

"And in the present circumstances, that means getting prepared for an increase
in volatility in financial asset prices, both stocks and bonds (and maybe,
currencies, too).

"Indeed, the most benign interpretation of the FOMC's intent in mentioning the
possibility of 'excess risk taking' is that the FOMC - read, Chairman Greenspan
- wants to interject some fear into the financial markets."

OK, we have set the stage. Now let's see how our characters act out the play.

Let's speculate that the Fed raise rates by a buck and half (1.5%) over the next
6-8 months. If long term rates rise along with the process, even if somewhat
slower, then my forecast (for this year) is largely intact.

But what if Hoisington and Hunt are right? What if long rates stay flat or even
drop? Then we get fairly close to an inverted yield curve. A small bump in the
economy, some softness here and there, and voila! We watch as the curve inverts
for 90 days. And then everyone but Blue Chip Economists note that a recession is
likely within 9-12 months.

The Problem of the End Game

McCulley has put his finger on it. It is the problem of the endgame I have been
writing about for three years. The Fed can either let the asset bubble (housing,
carry trade, etc.) continue and it will eventually go the way of all bubbles
(with much weeping and wailing), or they can begin to decrease liquidity and
hope for a soft landing.

They have already started the process. Interest rates are rising and they are
hinting at an even faster pace. The adjusted monetary base has been flat for
five months. Absolutely no growth. That is not the stuff of inflation.

Yet the risk is that the process of trying to let the air our of a bubble is not
that easy to control. They have been successful with only one soft landing in
the last 40 years in the mid-90's, although the recession of 2001 was quite mild
considered we had come off a huge asset bubble in stocks.

Raising rates will put downward pressure on housing, certainly will not help
corporate profits and will make the cost of debt service higher. It is a game of
chicken with the economy. If you allow inflation and an asset bubble, you make
the recession which will inevitable follow much worse. But can you keep from
causing a recession by deflating the asset bubble in the meantime?

There is much hand-wringing in certain circles about the US depending upon the
kindness of strangers - that we are dependent upon them financing our debauched
spending spree. By buying our bonds (those inscrutable Asians), they keep our
rates lower than they would otherwise be. What if they decided to stop buying
our bonds?

The opposite is just as big a problem, though. What if they continue to buy our
bonds and long rates do not rise, thwarting Fed policy and we see a continuation
of the asset bubbles the Fed (and any thinking observer) worries about? If the
yield curve flattens, that is certainly not good for many financial institutions
and their profits, which I should note makes up a large percentage of the S&P
500.

And that's my worry. That is what could kill my rather optimistic forecast for
2005. The Fed raises rates at a more than measured pace and long rates do not
rise gently along with them. That will surely soften the economy by the end of
the year. Rather than pushing the end game out for another year or two, we start
looking down the considerable maw of the recession dragon.

Of course, I doubt whether we can actually get a soft landing, given the extent
of the imbalances. One way or another, we end up in recession. But we do not
want one as a result of an asset bubble breaking. The Fed must pick which poison
we risk while trying to avoid having to take the medicine. How we get an
increased US savings rate (which is required to balance or at least mitigate the
trade deficit) without a recession is beyond me. But you can bet the Fed will
try.

But that doesn't mean I don't root for the home team. I hope they confound me! I
hope I am being overwrought and way too bearish. A soft landing - something like
93-94 - sounds quite nice.

It is somewhat analogous to my Texas Rangers, as unbalanced a ball team as there
is. We simply have no pitching. It is not realistic to think that we will see a
World Series at the Ballpark this fall. I will still root for them, but I don't
bet on them. But getting into the play-offs - a soft landing - would be nice.

China, California and a Few Details

My business partner from England, Niels Jensen of Absolute Return Partners,
comes to Texas next week. I will introduce Niels to real steaks, cheap currency
and Texas hospitality. Then we are off to La Jolla to meet with my US partners,
Altegris Investments and then off with them to a long weekend planning session.

I will write next week's letter a little earlier in the week, as I will not have
time next Friday. I have been gathering data for a letter on China for sometime,
and I think you will find it interesting. At least it will be a nice departure
from today's rather gloomy topic.

Next week promises to be a time with good friends, good food and a few visits to
Jon Sundt's (the president of Altegris) great wine cellar. I do so appreciate a
man who put up a wine 20 years ago just to break a few bottles out for my visit.

Your thinking cabernet and prime analyst,

John Mauldin
 
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re: above post

find this guy interesting...not my opinion.;)

he always turns over the real smelly stones....LOL.

tekno

46%C 27%S 27%I........come onbouncesweetheart!!
 
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