I made these predictions about the future direction of economies and markets before (November 2, 2010) the Fed’s formal announcement that it would print $600 billion more dollars to buy mid-maturity T- bonds, and before Obama’s humbling swing through Asia culminated in a G-20 summit that was only remarkable for how little was agreed upon and how little regard the participants thought of the world’s leading economy and its leader. Let’s see how things are panning out.
1) Oil will break $100 within six months. It may retrace its 2008 trajectory, and hit about $150 before plummeting to below $50 again, but probably not before the end of next year or the beginning of 2012. The reason it will rise is the same as always–inflation, i.e., a cheapening of the currency that the Fed is about to re-engineer. The Fed won’t actually get much domestic inflation, though. What will happen is that producers and suppliers will get richer, while intermediaries and end-use suppliers take a haircut fighting over declining markets. The end result will be a crash in SPX profits from their present bloated levels, and paradoxically, a crash in prices at all levels (retail and wholesale, etc.) once it becomes clear that the increased prices do not reflect expanded demand. This is nothing other than a cyclical return to the events of 2007/2008, that lead into the mini-depression of early 2009. The next mini-depression will start in earnest in the 1st or 2nd quarter of 2012. This analysis holds for other non-agricultural commodities (e.g., copper and steel), except that the trajectory is apt to be both higher and lower and on a shorter cycle than just oil.
The book isn’t closed on this on, but it looks as though the commodities markets had priced a bigger round of easing in, as practically all, oil included, have now retreated a bit from their levels before the announcement. It may well be that the front part of the cycle of increasing prices followed by crashing prices has already ready played, meaning that all we have left is declining prices. If so, the timetable for events will be moved ahead. Oil has declined about $5 from its recent highs of about $87, reached a week or so after the original post.
2) Agricultural commodities will roughly double from their present, somewhat elevated, levels before they crash again in late 2011/early 2012. By “agricultural” I mean anything that is grown for food. Things like cotton don’ t count. Cotton will crash from its historic highs soon enough. The reason agricultural commodities will spike, then crash, is much the same as that for other commodities, except that the demand for food commodities is not nearly as volatile as the demand for things like copper and steel, nor even oil. Oil and other energy sources have a more stable demand than does copper and steel (i.e., for all the economists out there, it has a higher inelasticity of demand), but its quantity demanded is more volatile than foodstuffs. People always have to eat. They don’t always have to drive to the shore for vacation. There is almost never any requirement that skyscrapers full of copper and steel be constructed.
Cotton is already coming down rapidly. Agricultural commodities have fallen off their recent highs somewhat. You can see in the following chart from Bloomberg (of four commodities indexes Bloomberg tracks), the dip in the last few days:
3) Stocks will similarly put in a climb, though not as extreme as commodities, and similarly crash. I’d say 30-40% up, nearly touching their 2007 highs by late 2011. Then a crash of about the same percent going into 2012. Sentiment drives the stock market, and after Obama has been put in his place by the Tea-Partying Republicans, sentiment will likely turn from anger to glee. But glee will return to anger by the next election cycle as the manic-depressive Tea-Party polity realizes it is not Obama’s fault that it seems their world is going to hell. Anger is never good for a bull market.
Given the SPX performance over the last few weeks, it seems the stock markets may also have peaked, but I don’ t think so. I believe this is a temporary, post-election blip that will resolve after the new Congress takes office in January.
4) Gold will be volatile, but trend up. Gold is not a commodity in the sense that oil is a commodity. It is not useful for much except jewelry and some industrial applications. But it is useful as a replacement currency, and its value depends heavily on the value of the fiat currencies it is reckoned as insurance against. The central bankers are all racing to the bottom, and as the saying goes, bad currency drives out the good. Supplies are more or less fixed in the short run, so gold’s moves will reflect sentiment about where traders think central bankers are leading their currencies, and sentiment amongst traders is always tricky to sustainably gauge. But all bets are off if a black swan shows up in the pond, i.e., if something totally out in left field appears, like a Russo-Chinese border war (it’s sort of happened before), or a Korean peninsula shooting match that goes regional, pitting perhaps Japan and South Korea against China and North Korea. War with Iran wouldn’t force gold off the charts because it is already too highly anticipated. Iran would be a telegraphed war, such as Bush Sr had in Iraq, “If you don’t do “x” by “x” date, we’re gonna get you.” Markets should already have discounted the possibility of war with Iran, since it has been discussed so often and so openly since the Iranians started moving towards attaining a nuke. But anything else–say, a huge and successful terrorist strike–would send gold skyrocketing. I hold about 5% of my portfolio in a gold ETF, just in case.
Gold has been volatile, and trending up, although down the last couple of days.
5) Residential real estate prices will decline, perhaps nominally about 10-20% from present levels. But mortgage rates will decline even more, 50-75%, until the banks are effectively, on a real basis, paying mortgagors to borrow money from them. So the 10-20% decline in nominal home prices will be exceeded by a decline in the price of money used to purchase residential real estate, which will mean a 30-40% decline in the monthly cash required to “own” a home (by “renting some money”). The foreclosure mess will serve as the catalyst for pushing nominal prices down. The Fed’s quantitative easing will take care of the rest. Yet the market will still be vastly oversupplied. Which will mean this decline in prices is only a way-point for further declines. The bottom in housing won’t come until mid-2013 at the earliest, and even then, the bottom will look like the Arabian desert–a vast expanse of featureless nothing leading in every direction to more featureless nothing.
Housing prices will appear to have risen in the next little while because of the halts and delays in foreclosures. Foreclosures always drive down average and median prices. Ignore it. Housing has a ways yet to go. Down. And interest rates are up a bit after touching an all-time low a couple of weeks ago (according to Freddie Mac stats). They too, on a real basis, should continue to reach new lows.
6) The financial system will not implode, but it will limp along like the zombie that it is, continuing to feed on the brains of government lackeys trying to keep it afloat. Most commercial banks are insolvent, or would be, without the Fed’s carry trade to fill holes on their balance sheets (borrow at zero percent from the Fed and turn around and lend at 2.5% or so to the same guys you borrowed from–neat, huh?). The Fed’s quantitative easing that will start sometime before the end of the year (it may already have begun, but only a few traders and the Fed itself would know) will squeeze bank margins in the carry trade somewhat, because it appears the Fed’s purchases will be directed at the long end of the bond market (greater than five years). So, the Fed, (or Treasury, effectively a distinction without a difference) might buy and hold some crappy bank assets (mortgage backed securities comes to mind) to maturity, paying full value for them, helping to get them off the market and to pretend they aren’t worth only about half of their original value.
This one will take time to play out, but it will always be simmering on the back of the stove.
7) The Euro will be in more or less constant crisis from now until it finally collapses and is replaced by sovereign currencies around 2012. The discordant outcomes of Northern Europe’s healthy economies relative to their poorer Southern cousins will force the abandonment of the currency, as the Germans, French, Dutch and Danes refuse to continue subsidizing the profligacies of the Greeks, Italians, Spaniards and Portuguese.
This one is already happening, with the Irish problems. I should have had Ireland on my list, but the list wasn’t meant to be comprehensive. The Euro is rapidly falling, which means the dollar is doing relatively well, which means commodities are declining. With all the world’s economic systems playing mercantilist games against each other through currency manipulations and thereby effectively canceling each other’s currency shenanigans out, the strongest economic systems will ultimately see their currencies gain. US fundamentals are stronger, overall, than European fundamentals, so it will win in a battle between the present, but declining, giants. The developing nations have stronger fundamentals than the US or Europe, so they should win in their currency battles. Japan is an outlier that is difficult to explain. It seems the more Japan prints, the more domestic deflation and currency appreciation it gets, perhaps because Japan is still an exporting powerhouse, and sells most of its debt domestically. Here’s what Matthew Lynn of Bloomberg News recently said about the Euro area:
In each country, it will be a different trigger that causes a collapse in financial confidence. The root cause is the same, though. When the euro was launched, it was a big bet that sharing the same currency would make a group of very different economies converge, and so allow the European Central Bank to operate a single monetary policy for all of them.
It was an interesting theory, but it turned out to be wrong. The economies are just too different to allow a single central bank to manage all of them. Interest rates are always wrong everywhere. How that expresses itself varies. In Greece, it was a fiscal crisis. In Ireland, a banking collapse. In Spain, a construction bubble that burst. In Germany, a massive trade surplus. But, like a river looking for the sea, it always comes out somewhere.
Back to my post:
Overall Conclusion:
History is cyclical. It turns like a wheel on the ground, going ’round and ’round in a similar pattern, but always covering new ground, never able to arrive at quite the same place as before. In other words, like Twain famously said, “History doesn’t repeat, but it rhymes”. It’s about time the US cycles back to the place where it last peaked and started falling, circa 2007. The bond markets stand as stark evidence that the Fed is in the process of successfully re-engineering an asset/commodity bubble, that can and will only end in tears. The bond bubble was the first marker in 2007 that something was amiss. As soon as PIK (payment in kind) bonds again become the rage, it will be clear that something is wrong. Given even more and cheaper money on the way from the Fed, it’s likely the day of reckoning is not far off.
The day of reckoning seems to be approaching rapidly, but I think will hold off until the 3rd quarter of 2011, as it takes time for the new Congress to prove it is just as inept as the old Congress.
The American century is past. No matter what happens from here, the days of unrivaled American economic, political and military hegemony across the globe have ended, if for no other reason than a rising China, India, Brazil and Indonesia, with nearly half the world’s population, will make America less important by comparison. This will have a profound impact on American economic performance. The New Deal did not save the US from the Great Depression. Victory in World War Two did. It created the greatest and richest empire the world had ever seen. Victory in the Cold War propelled the empire to even greater riches. Now there is no one left to defeat militarily, and the US hasn’t the will to defeat any of its rising rivals economically. Which is why America will enter a period of slow, inexorable decline. The colonizing days are over, no matter how hard it’s citizens tried in the real estate boom to turn their houses into personalized colonies, growing them ever larger and more opulent with each quarter’s growth in prices. America adamantly refuses to do the one thing that would return it to competitiveness internationally, i.e., it refuses to allow a nominal decline in its wage rates.
This was on stark display at the G-20 summit where even the eloquence of Obama wasn’t even to invoke awe amongst the leaders of the world’s biggest economies. The developing world is rapidly realizing their nascent power and is beginning to understand that any time a developed country wishes their agreement to a policy it generally means the developing country gives up something without getting anything in return. This summit marked the first real glimpse at what the post-Pax Americana century we are in will look like.