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Forex Blog - Whatever Happened to Decoupling?Whatever Happened to Decoupling?
August 15, 2008
By John MauldinA Mid-Year CorrectionWhatever Happened to Decoupling?The UK Starts to SlowA Recession by Any Other NameWhat's a Central Banker to Do?
The old mantra was that if the United States sneezed, the rest of
the world would catch a cold, as the US was seen as the main driver of
world growth. That was then. Economists and analysts began to argue
that China and the developing markets were starting to provide a
consumer base for the world. And Europe's new and growing markets would
be able to stave off problems from abroad and stay on their own growth
path. The world, we were assured last year, would not suffer from
problems in the US economy.
Today, we look at evidence that
this might not quite be the case. And if it is not, those who look for
diversification in global markets may be disappointed. Also, I quickly
look back at my January forecasts and feel it may be time for a
mid-course correction. It seems I may have been a little too
optimistic. It should make for an interesting letter.
a quick commercial. I spent two days at the Caves Valley Golf Club
outside of Baltimore with good friend and business partner Steve
Blumenthal, the president of CGM. He has developed a platform of money
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interested in outside money management take a look at them. Normally,
to take a look at the managers, we have you sign up to get a "pass" to
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at least for this week. If you would like to look at a manager I think
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fill out the form, and they will call you. http://www.cmgfunds.net/public/mauldin_questionnaire.asp
as always, if you have a net worth of $1.5 million or more and are
interested in hedge funds, commodity funds, and other alternative
investments, you can go to www.accreditedinvestor.ws
and one of partners from around the world will show you what is
available on their platforms. (In this regard, I am president and a
registered representative of Millennium Wave Securities, LLC, member
FINRA.) And now to the letter.
A Mid-Year Correction
I wrote in my January 4 letter the following predictions:
let's get to the predictions. I think that we are in a recession for
most of the first half of this year, and that we begin a slow recovery
in the second half. It will be a Muddle Through Economy for at least
another year after that. That would suggest that most companies will
come under serious earnings pressure. If history is any indicator, that
means we should see a bear market in the first half of this year. How
deep will depend on how fast the Fed cuts, but I don't think we are
looking at anything close to the bear market of 2000-2001. Still, I
wouldn't want to stand in front of a bear market train.
spending is going to slow, and it will be slower to rebound, for
reasons outlined above. That will also make the recovery in the stock
market a little slower. But I expect to become bullish on the market
sometime this summer, if not before. I'm looking forward to it."
be blunt, that optimism now seems misplaced. I think we are likely to
stay in recession for perhaps the rest of the year and well into 2009
before we start a very slow recovery. It is not time to get bullish on
stocks, as I have been writing for the past few months. Earnings are
going to continue to come under pressure, and earnings are what drive
the stock market over the long term. We could see total S&P 500
as-reported earnings drop below $50. You do the math. Even with a 20
multiple, that does not yield a pretty picture.
I think we are
going to test the recent lows and then watch the market go lower as the
market gets disappointed in the earnings from the third quarter, and
re-test those lows again. We are in for an extended period of Muddle
Through, while we wait for the housing market to find a bottom and the
credit crisis to abate. Banks and other institutions have written off
about $500 billion. There is at least another $500 billion to go. The
amount of capital that is going to need to be raised is astronomical,
and it is going to be very dilutive to current shareholders.
did predict that the euro would top out against the dollar this summer,
and that looks to be the case, although the dollar went lower against
the euro than I thought it would when I forecast $1.50 about 4-5 years
Whatever Happened to Decoupling?
I was reminded of an article by Desmond Lachman of the American Enterprise Institute (by Leo Kolivakis of www.pensionpulse.blogspsot.com). Lachman wrote these very prescient words last January in a paper called "The Myth of Decoupling." Quoting:
the 'decoupling' thesis has little support in theory or in practice.
Its proponents overlook the fact that during the past five years the
U.S. economy grew faster than all the other G-7 economies. During that
time, America's economy remained the principal generator of global
aggregate demand, accounting for around one-fifth of global imports and
25 percent of global production. This evidence suggests that, as in the
past, if the U.S. economy sneezes the rest of the world will catch a
"... A number of the shocks presently affecting the U.S.
economy are global in nature, and are already slowing European and
Japanese growth. The credit crunch flowing from America's subprime woes
is causing a global increase in market interest rate spreads and a
global tightening of bank lending standards. This is hardly surprising:
almost half of all U.S. asset-backed subprime mortgage securities were
"... The 'decoupling' optimists are ever
hopeful that China's rapid growth, together with the rest of Asia's
emerging market economies, will offset any U.S. economic downturn. But
they tend to forget that Asia is filled with export-dependent
economies: in some countries, exports to the United States
[emphasis mine] account for more than 10 percent of annual GDP. The
"decouplers" also forget how relatively small these Asian economies
still are, at least in relation to the G-7 industrialized economies.
Even the vaunted Chinese economy is barely 15 percent the size of the
We are now seeing the major economies of the world
go into simultaneous recessions and in many of them elevated inflation
as well, giving way to stagflation. Let's first take Europe. Today we
learned that "GDP growth is easing in a number of European economies as
highlighted by national accounts figures out during the week. The flash
second quarter GDP data for the euro zone noted a 0.2% q/q contraction,
following a 0.7% expansion in the first three months of the year. This
was primarily the result of a 0.5% downturn in the region's largest
economy, Germany, and a 0.3% contraction in second biggest, France." (www.economy.com) The chart below shows the latest data results.
it's not just Germany and France. "Preliminary data suggest the Italian
economy also contracted 0.3% during the quarter, the Netherlands
reported no growth, and Spain grew at its slowest pace since the 1993
recession, with a minimal 0.1% expansion. The Spanish government fears
recession in the second half of the year and called for emergency
discussions on Thursday to deal with the situation. Latvia and Estonia
also contracted in the second quarter, with Estonia reporting a
technical recession after also shrinking in the first three months of
the year. While no flash estimate is available for Ireland, the economy
is on the brink of recession."
Inflation in Europe is running
at 3.6%. Since the European Central Bank has just one mandate, and that
is to provide for a stable currency, it will be difficult for them to
ease this year.
The UK Starts to Slow
Bank of England is forecasting a flat (0%) GDP over the next year. The
United Kingdom is probably already in recession, but the problem is
that the central bank is going to have difficulty cutting rates, with
inflation at 4.4%; and that problem may get worse, as major energy
suppliers like British Gas are announcing price increases of as much as
35%. Producer prices in the UK rose by 10.2% in July. The head of the
British central bank, Mervyn King, is forecasting an inflation of 5%.
in Asia? Real GDP declined 0.6% in the second quarter in Japan. Chinese
stocks are forecasting trouble, as stocks are down more than 54% this
year and 60% since the peak last year. And it is not just China. Stock
markets all over Asia are in serious decline, although my friends at
GaveKal note that Chinese stocks may be seriously oversold and a buy
from here. I think I would wait until we see just how much a prolonged
US slowdown will affect Asian economies and exporters. And inflation
pressures are evident all over Asia. Producer prices in China are
rising more than 10%. Inflation is at 12.4% in India, a 16-year high.
in the US? Data came in this week that was rather shocking. July CPI
rose by 0.8% in July and 5.5% year over year, and core inflation on a
three-month basis (less food and energy) rose by 3.4%.
A Recession by Any Other Name
the comfort the bulls took in the fact that GDP when first reported was
a positive 0.6% in the fourth quarter of 2007? Now is has been revised
to a negative 0.2%. As I have repeatedly said, GDP numbers will be
revised downward in this part of the cycle, but maybe a few years after
the fact when real data and not estimates are available.
look at this piece from David Rosenberg, the North American Economist
for Merrill Lynch. He does a good job of telling us why GDP estimates
that suggest the economy is not on recession may not reflect the facts
on the ground.
"You'll miss a lot of action waiting for GDP to go
negative. More to the point, if you're waiting as an investor for GDP
to actually turn negative, you're going to miss a lot of action along
the way. I think the best example is to just go back to Japan. They had
a real estate bubble that turned bust and they had their own credit
contraction back in the early 1990s. Guess what; Japan didn't post its
first back-to-back contraction of real GDP until the second half of
1993. By the time the back-to-back negative that people seem to be
waiting for happened, the Nikkei had already plunged 50%, the 10-year
JGB yield rallied 300 basis points, and the Bank of Japan had cut the
overnight rate 500 basis points, which said a thing or two about the
efficacy of using the traditional monetary policy response of cutting
interest rates into a credit contraction (as we're now finding out here
in the US)."
Dating the recession is a very scientific process:
point is we can't make the assumption that we've avoided a recessionary
condition in the economy, just because we have so far managed to avoid
back-to-back quarters of negative GDP. I'm just telling you as the
economist that it is basically irrelevant. The only body that
officially makes the call on the broad contours - when the recession
started, when it ends, when the expansion starts, when it ends - is the
National Bureau of Economic Research, the NBER. It's a very scientific
process. It's not a gut check or a judgment call.
actually be welcoming the recession call. When they make the
determination - it's very interesting, by the way - when they make the
announcement that the recession began, when they actually date it for
us, traditionally we're a month away from the recession actually
ending. The announcement, in fact, is going to be a rather cathartic
event, something we should actually welcome happening, but so far they
are still taking their sweet time in making the proclamation.
"Four factors used to determine recession:
NBER relies on four different variables. The first is employment. Now
I've told you before; employment is down seven months in a row. Does
employment go in the GDP? The answer is no. Is it correlated? Yes. Does
it help grow the business cycle? Of course.
2) Industrial production
next variable is industrial production. Does that go into GDP? The
answer is no. Does it help grow the business cycle? The answer is yes.
This is a number that comes from the Fed. The GDP comes from the
Commerce Department. It's a very important variable.
3) Real personal income net government transfers
next variable, the third one, is real personal income excluding
government transfers. This metric is now down four months in a row.
Does personal income go into GDP? The answer is no; of course, it
doesn't. GDP is all about spending. Personal income goes into gross
domestic income, which is another chart of the national accounts.
4) Real sales activity
fourth variable and the only variable that actually feeds into GDP is
real sales activity in manufacturing, retail and wholesale sectors.
Recession probably started in January. When I take a look at these four
key indicators that define the broad contours of the business cycle,
they all peaked and began to roll over sometime between October of last
year and February of this year. I am convinced that when the NBER does
make the final proclamation, it will tell us that a recession
officially began in January. Of course, to any market person, this
would make perfect sense, because of when the S&P 500 peaked. It
did a double top into October, right when it usually does, before a
"This recession won't end before mid-2009, in
our view. Now I'm just giving you the rearview mirror. What's most
important to you folks is let's look through the front window and see
when this recession is going to end. The tea leaves that I'm reading at
this point in time show that this recession is not ending any time
before the mid part of 2009, which would mean that, if you're looking
for, not the Mary Ann Bartels intermediate bottoms, but the fundamental
bottom, I don't think you can expect to see it before February or March
of next year, if I'm correct on when this recession ends. Historically
the S&P 500 troughs four months before the economy actually hits
its bottom point."
I agree with Rosenberg. And if we see a
recession lasting into 2009, then earnings are going to be under a lot
of pressure. Buying index funds today could be very risky to your
What's a Central Banker to Do?
bankers everywhere are faced with a serious dilemma. Do they raise
rates to fight inflation, cut rates to stimulate their economies, or
sit tight and hope that prices moderate as the world economy slows?
Hope is an interesting strategy for a central bank, but it may have
come to that.
In short, the world has not decoupled, but is more
closely intertwined because of the global financial community. Housing
problems and excesses in California (and the rest of the US, the UK,
Spain, etc.) affect banks in Europe and Asia and the US simultaneously.
cannot have a worldwide recovery until the financial crisis in the
major lending institutions is dealt with. A functioning banking system
is the lubricant for a world economy, and the banking industry is
cutting back on loans and tightening the standards by which they do
make loans. Look at these survey results from Northern Trust:
reality, it is not just mortgage lending that is getting tighter. Every
survey done on any type of lending worldwide shows bankers are setting
tougher standards; and most are simply lending less, partially as a
result of shrinking capital ratios. Until lenders have adequate capital
to be able to make loans, it will be hard to see anything other than a
very tepid recovery sometime next year.
Look at the graph
below. The spread of the difference between US 10-year treasuries and a
30-year mortgage is the highest in over 22 years. In May of 2007 it was
1.37%. Today it is 2.53%. The historical average is 1.68%. That means a
mortgage costs almost 1% a year more than it would under a normally
functioning market. That reflects that lenders are having trouble
finding investors who will buy their mortgages, and of course it makes
housing less affordable and puts off the day when inventories will
again be reasonable.
line is that there is a long way to go before either the world economy
or markets will be seen as functional. I continue to believe the data
suggests we are still in a secular bear market and that valuations are
not anywhere close to signaling a new bull market. Paying attention to
daily market movements to confirm your bias one way or another is
pointless. Daily market moves are random noise.
to the fundamentals like earnings and valuation. In this type of
market, you should be looking for absolute-return types of investing
rather than relative-value index funds. And absolutely avoid anything
linked to the US consumer or financial stocks unless you have some
special knowledge of a specific situation. There are more write-downs
and earnings disappointments to come.
Weddings, Baltimore, and South Africa
noted above, I met with Steve Blumenthal and wealth manager Cliff
Draughn at the Caves Valley Golf Club on Wednesday and Thursday this
week for a quick trip to talk business and get in my first real game of
golf in over two years. This maybe is the most beautiful course I have
ever played, and Cliff was a great host. Oddly, as the game went on, I
started to get some twinges in my right arm, but I thought it was just
a little stiff from not playing golf for so long and tried to work it
out. By the 17th hole I just couldn't follow through as the pain in the
forearm was too much, and so I called it quits. The pain continued
through the night coming back on the plane. And this morning I woke up
to find my right forearm and up to my middle inner bicep was one ugly
bruise. Not sure what happened. That is a first for me. But I worked
through the pain and finished the letter tonight.
I will be in
Cape Town, South Africa, on September 21-23 to do a speech. I will go
back to Baltimore to attend my good friend of 25 years Bill Bonner's
60th birthday party the first weekend in September. He is the one of
the best pure writers I know. You can read some of his essays and
subscribe to the free Daily Reckoning (be warned: Bill is quite bearish) by clicking on the following link: http://www.dailyreckoning.com/rpt/mauldin.html
wedding was a spectacular success, and I know Tiffani and Ryan will
post pictures and video when they get back from South Africa. I have to
confess that when I saw Tiffani she was so beautiful that I actually
teared up, and then we both got misty-eyed. It was a very special
moment. I surprised myself getting so emotional.
As I was walking
through the dining area before the wedding, I noticed that they had put
out a treasure chest on one of the tables. I assumed that it was for
putting gifts into. As I walked by, I tried to lift the lid. Turns out
it was a very realistic looking cake and I put my thumb through the top
of the "lid." Tiffani had personally designed every aspect of this
wedding, and I had just left a very large impression on one part of it.
When I sadly told Tiffani, she just laughed. She said it was such a
"Dad thing" to do and made the night perfect. I just wish the Dad
things I do weren't so embarrassing. Oh, well.
As I did my toast,
right before the fireworks, I welcomed Ryan into the family as
Tiffani's six brothers and sisters, plus in-laws, gathered around. Part
of it went something like this. I mentioned to the crowd that Tiffani
had been responsible for the total design of the tables, decorations,
dinner, the flower arrangements, the (very) elaborate cake, etc. No
detail went by without her input. And then I added:
bad news is that you have married a lady who, just as she organized
this wedding, is going to pay attention to every detail in your life,
making sure you stay on your toes. I know that from personal experience
from working with her for ten years. But the good news is that she will
also make your life as beautiful as this wedding. You have my treasure.
Take care of her."
Your still misting up analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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