Slip Sliding Away

John Mauldin | Thoughts from the Frontline
October 19, 2001

One of the constant complaints of Yankees who come to Texas is that those of us who are natives do not know how to drive on ice. This is true. But that is because we only get to practice about once a year. We don't seem to remember what to do from year to year. Is it steer into the slide or away from it? What do we do when we start sliding back down the hill? It can cause huge traffic tie-ups.

Slip sliding away,
Slip sliding away,
The more you near your destination,
The more you slip slide away.

-Paul Simon

The problem is traction, or the lack of it. For 99% of the year, as long as we watch the tread on our tires, we have traction. But getting traction on ice is a problem. The trucks, of course, are sent out to put sand on the roads. But until the sand gets there in enough quantity, anyone venturing onto Texas freeways in an ice storm is taking their life into their own hands. My poor wife was caught in a freak storm last year, hit some "black ice" and totaled her car. She was lucky and survived without injury, but it could have been serious.

Why are we talking about Texas drivers in an economic letter? Because that is the best analogy I can find to set up today's discussion of the Fed and the economy of late. Like a Texas driver on ice, the Fed has never experienced the combination of a world-wide recession and deflation while our economy slides into recession. It is new territory. They are pouring on the sand of rate cuts, trying to find traction, but the more they near their destination of zero percent rates, the more the economy appears to be slip sliding away.

For the past few weeks we have been exploring a philosophy of investing. Today we jump back into the arena of the economy. A lot has happened in the past few weeks, so keeping those thoughts about ice on hold, let's jump right in.

Is That Inflation Hiding Behind that Tree?

Time for a gut check. Over the past few years I have made some very contrarian calls which have turned out to be generally on target: increasing deflation, a rising bond market, a recession, gold going nowhere, a dropping stock market, energy going up and then back down (although the cycle has been somewhat longer than I originally thought it would be) and recently betting on the Euro and against the Yen. I should probably quit while I am ahead.

A lot has happened since September 11. The question is: are the terrorist attacks and the reaction to them simply pushing us further in the direction we were already going, or is something fundamentally changing?

Perhaps the single most critical tenet I hold, and the most vulnerable, is my view that we are in a global deflationary cycle. That is what we are going to review today. If the deflationary trend were to change, then our investment portfolios and our outlook need to change as well. Consequently, this is an important e-letter.

"A wise man," my father told me, "changes his mind. A fool never does." Mostly he said this when I complained about some change he made which I didn't like, but the thought has stayed with me. (Coincidentally, my kids don't like it when I use it anymore than I did.)

Is it time to change my mind about deflation? Let's look at the numbers.

A number of commentators are arguing that we will soon see a resurgence in US dollar inflation. Some of these are analysts I deeply respect, and others are simply knee-jerk curmudgeons who write stories to scare investors into buying some product. They state this for two reasons. First, the Fed has put a massive amount of money into the economy on a scale unprecedented in US history. They would argue that this has always led to inflation. This argument has a lot of credibility as History is on their side. Secondly, they point out that Congress is going to introduce a large fiscal stimulus into the economy. Like Elvis, there are numerous reported sightings of the long dead John Maynard Keynes in Washington, DC. This fiscal stimulus, we are told, is also inflationary.

There is an influential group literally called the "shadow committee", a group of economists who monitor Fed activity. They are essentially from the economic school called "monetarism". This school of thought says the best way to keep inflation in check is to control the supply of money. This group, famous economists all, are urging the Fed to stop cutting rates and urging caution on government growth before inflation returns.

It should be noted that this group is always worried about inflation. They are fixated on it. But they are influential.

I should note that for the last few decades I have generally agreed with this group. You can look at history and see a connection between money supply growth and inflation. That is, until recently. The money supply has been growing well above long term trend for several years and inflation is going down.

My position has been that the Fed is fighting deflationary economic forces in the world. What would normally produce inflation (rapid growth in the money supply) has simply masked the effects of deflation.

Monetarists say inflation is an increase in the money supply. But is it? I guess it could depend upon what your definition of "is" is.

There is monetary inflation and there is price inflation. No question, we are seeing monetary inflation. But it is not translating into price inflation. Monetarists would say, "Not yet. Just you wait. Sooner or later it will. The chickens will come home to roost."

Well, maybe. But if you drop back and stop focusing on just the monetary supply tree, you see a completely different type of forest. And it is deflationary green. Let's look at some of those trees.

First and foremost, we are in a global economy. What effects one country has implications around the globe. Let's say the world economy is a 3 ton truck. The US Fed can pull about 2 tons, but Greenspan needs some help from his European and Japanese counterparts. And they are pulling the other way. If the road is icy, this is especially not a good thing. You want your wheels all going in the same direction.

The European Central Bank is clearly tightening. I do not understand their stance, and I doubt Greenspan does either. That is why the Euro has weakened as of late, and will probably stay weak until they do loosen up.

Germany, which is the bulk of the European market, is clearly slowing. German Finance Minister Hans Eichel swore 6 months ago that Germany would grow 2% this year. Now he hopes to see around 0.75% this year. (Note the word "hopes".) Of course, growth will be "between 1 and 1.5%" next year, he said, revising a previous forecast of 2.25%. (Bloomberg)

Not a chance, Hans. World trade is rapidly slowing. Emphasis upon rapidly. And Germany is more dependent upon world trade, especially manufacturing, than we are. Business confidence in Germany is as low as it has been in 28 years, and is plunging monthly. It will get worse, as Germany's customers are in trouble.

Let's look at some numbers, courtesy of Greg Weldon. Taiwan exports have fallen off the table in the last six months. "Taiwan's DREADFUL September trade figures --- a 50% yr-yr plunge in exports to the US, a 50% plunge in exports to Japan, and a 49% plunge in exports to the EU."

If you are in Taiwan, you are not talking recession. You are talking depression. End of the world as we know it. Gloom and doom of Biblical proportions. Think about those numbers for a moment. You are running a business, everything is going well, and in 6 months 50% of your business goes away. How do you survive? Lay-offs, cut-backs and other major surgery, which must be of the painful variety. And you are not buying new equipment. You are slashing prices just to get some cash flow. You are in a "last man standing wins" scenario.

Taiwan is not an isolated example. Weldon rewinds the numbers from Singapore this week:

"--- Exports to US ... down 46.0% yr-yr
--- Exports to Japan ... down 29.0% yr-yr
--- Exports to Taiwan ... down 40.9% yr-yr
--- Exports to EU ... down 26.8% yr-yr
--- Export to Malaysia ... down 36.1% yr-yr
Recession FOR SURE ... and arguably a downright depression."

In April, the numbers from these countries were down less than 1%. Last year they were growing rapidly. Businesses were planning and creating production capacity based upon growth as far as the eye could see. Now they are doing triage, hoping to survive.

Argentina is imploding as I write. The numbers are bad everywhere you look. Even when we look in our own back yard.

The Ugly Three Amigos

First, Three Amigo capacity utilization is down .9% in September, to 75.5%. Manufacturing capacity utilization is down to 73.8%. These are the worst numbers we have seen since 1983. Ugly is the correct technical term for such postings. When you can produce 1/3 more products than you can sell, you are not looking to buy more equipment. Capital expenditures in the US is way down, and unlikely to increase soon.

Three Amigo junk bonds are on the floor. In terms of pure NAV on the funds I watch, you have to go back 10 years, in the middle of the 1990 recession, to find lower numbers. In terms of NAV, junk bond funds are down 40% from their highs.

Industrial production numbers are even uglier. They have fallen for 12 straight months, the first time it has had a streak this long since 1944! When the next NAPM numbers come out in a week or two, this Three Amigo is likely to be down further.

Let's put a final nail in the inflationary coffin. Prices are in retreat. The Philadephia Fed reports, "For the fourth consecutive month more firms reported paying lower prices for their purchased inputs (24 percent) than higher prices (2 percent). The current prices paid index fell from -13.2 in September to -22.1, its lowest reading in the history of the survey. With regard to prices of their final manufactured goods, more firms reported decreases (22 percent) than increases (7 percent). The prices received index fell slightly from -12.2 last month to -14.9."

This is price deflation. There is no other way to interpret it. "The lowest reading in the history of the survey." Only a few industries have any ability to maintain or raise prices.

The US has not experienced numbers like the above for over 60 years. That is because we have not been in a deflationary environment for over 60 years.

There is a global glut of capacity. I predicted this two years ago, and now it is sadly coming to pass. In an optimistic wind the world built more factories to build more things than we can actually buy, much less afford. Now we reap the whirlwind of companies and nations competing on price to keep those factories busy. This is major league deflationary.

Did you buy a new car last month? A lot of people did. Did Ford or GM make money on those cars? No, because they were buying sales with deep discounts to keep their factories busy. And what really happened is that the just lured buyers into their showrooms were those who planned to purchase a new car soon anyway. The industry is suggesting we will see new car sales slow in the near future.

The American consumer is getting nervous. Imports this month were again down big. And that hard to understand statistic "the velocity of money" of cash (or MZM for you economists) has dropped to the lowest point for 18 years. (I can find no data from before that time.)

By that, I mean that people are spending their money more slowly. This is significant, and we will come back to it in a second.

For those of you who are statistic nuts, like myself, or just masochistic, you can go to a wonderful site maintained by the St. Louis Federal Reserve. http://www.stls.frb.org/. There are hundreds of charts.

In particular, I pay close attention to the adjusted monetary base. Right after September 11, you can see a HUGE jump in the base. Monster. Once in a lifetime. Then, starting a few weeks ago, you can see the number fall right back down the same cliff it climbed. Look at it for yourself. http://www.stls.frb.org/docs/publications/usfd/page2.pdf

Notice a small increase since that drop. Draw a trend line. We are back on trend. The money supply is still growing at a large rate, but it appears we are back to the trend we were on prior to 9/11.

But what about cash (or MZM or money of zero maturity)? It jumped $170 billion in the two weeks following the event, and has gone sideways to down since then.

In short, a one time jump that is a little more 1% of our economy, which certainly has lost more than that amount in GDP since then.

Example: CNBC was interviewing one of the Tisch family of Loews hotels (I think it was Jonathon), who is the head of the Travel Industry Business Roundtable. He said he expects over 1,000,000 jobs to be cut from their industry by December, if there is not a quick turn-around. He admitted that hotels are using rate cuts to "lure" travelers back. My daughter, in DC this week for a convention, called the convention hotel, the Marriott, and rates were still high. But across the street, at the boutique Hensley Hotel, one of my favorite hotels in DC if you can get in, prices were down 40% from one month ago and you could get a room with only a few days notice.

Whether it is widgets or rooms, when prices drop that much, that is price deflation.

In looking at hundreds of stories this week, I saw this startling news in no other place than from (once again) Greg Weldon. In Japan, two regional banks filed for bankruptcy. Normally, no big deal. Except for the details in the accompanying press release. Currently, the Japanese government guarantees all deposits of the banks. But in April that guarantee dropped to 10,000,000 yen, or about $80,000. The quote from one of the banks: "Since all deposits will be protected before the payoff system begins, we decided to file for bankruptcy with the authorities now, to limit damage to our clients."

The implications are huge. I predict this will be the first of a tidal wave of bankruptcy filings. Everyone knows that Japanese banks are sitting on huge bad debt portfolios. The government has been trying to get them to clean them up for years.

What Japanese consumer will leave assets in a bank that will lose the full backing of the government until they know the bank is solvent? Not risk adverse mama-san. And how can they know? They can't, unless the government is stepping in. Hence, as more banks file for bankruptcy, it will have the perverse affect of making those who are in good shape file anyway in order to re-assure their customers their money is safe.

In essence, Greg, as I think about it, this will amount to a nationalization of the banking system, and a nationalizing of the bad debt problem. Just as we did in the S&L crisis of the 80's, the Japanese government will step in. Weldon points out this will mean lending activity will dry up while some bureaucrat tries to get his hand on the bank portfolios. This has huge deflationary implications. How do you expand the money supply when you are already at zero interest rates and the banks aren't lending?

The Japanese are understandably deserting the yen, as "domestic investors are fleeing, as per the HUGE 1 trillion yen plus outflow in EACH of the last two weeks in the category of Japanese investor purchases of foreign bonds."

Oh, just one more problem. The Japanese government has a debt burden that makes ours look small. They have little room to finance their deficits, stimulate the economy and absorb the huge bank debts. They cannot do it all at once. Something will have to give. What that give will be will be the yen as it drops over the edge.

But then isn't that consistent with what the Japanese government has been saying they want? They want a lower yen so they can be more competitive. They will get their wish.

Sayonara, Japanese yen.

Let's wrap up the inflation/deflation debate.

1. The Japanese cannot pull their part of the 3 ton truck. The Europeans won't, or haven't as of yet.

2. The Fed doesn't seem to be continuing with its policy of massive dollar infusion. So far, it just seems to have stabilized things, and is not causing the economic pulse to race out of control. Things seem to be back on trend.

3. There is a global capacity glut that simply is not allowing prices to rise, and are in fact falling.

4. The price of basic commodities are falling and are at their lowest levels since 1986. Oil and gas prices are coming back down. There is NO inflation pressure from the basic commodities.

5. Bank loans and leases are down for the year. The velocity of money is down. Monetary policy is back on trend.

6. Let's go ahead and use the D word. Global trade is sliding into a depression.

In short, there is the real danger the Fed is pushing on a string, just as the Japanese did in the early 90's. We have had 9 rate cuts, will have a 10th in a few weeks, followed by another in December. The Fed rate will go to 2%. Book it. But we have yet to find traction. None of the indicators we are looking for to show some economic signs of life have turned positive. You cannot have a recovery until some of these numbers start to recover. If the Fed does not cut rates twice in the next two months, you do NOT want to be in the stock market on that day.

Bottom line: I just can't find the inflation in the pipeline. I understand the arguments, and would have made them myself in the past, but until the Fed gets some help from the Europe and Japan in reflating the world economy, deflation is the name of the game.

Do we need to watch it more closely? You bet. But a serious review shows no sign of inflation. If there is to be serious inflation, it will be later, not sooner.

The Fed is like that Texas driver on ice. They have never experienced a time when they could not stimulate the economy with nine rapid rate cuts, and two more on the way. This is a new environment. They are revving the engine, trying to gain traction, but they are slip-sliding away, back down the hill. When it catches, will it start back up slowly, or will it leap ahead, perhaps careening into the side of the road? Like the Texas driver, they don't know either, because they and we have never been here before. They just don't know what else to do. Sliding back down the hill is dangerous, so you try to go forward and hope for the best.

What it will mean is that bonds will be even more volatile. Every report will move the market. My favorite fund, the leveraged Target 2025 fund, will be appropriate for only a portion of your bond allocation, and then only if you can deal with the volatility. Those seeking less volatility and safety should go to medium and short term bond funds. I still think bonds are going to be the way to go for the near future, but it is likely to be a much rougher ride.

The original question was, "Has the direction of things changed since 9/11?" My answer is "no". All that event did was to push us further down the road we were already on.

Did it stall a rebound and make things worse? Yes. Instead of a 6 month mild recession, it is likely we will see a full year of a more serious recession.

Will the economy find traction? Yes. Rate cuts and other stimulus do matter, and the American businessman will adjust. Either the Fed provides some traction, or we slide to the bottom of the hill and American business stops the truck, puts on chains and we take off again. My bet is on the American business person and the free market. Hopefully, the Fed and the government will not make it tougher. In any event, a recovery is in our future. We are NOT Japan.

It now appears to me that The Bottom is at least a month or two off. Things could begin to turn around late this year or early next, although we probably stay in recession for the first half of the year. I think (hope?) we see a second half recovery, as Europe will eventually step up to the plate to carry their part of the load.

I still think the stock market has more downside.

Tortilla Soup

Want to feel good after reading my economic analysis? Go see, and take the family, to the new movie Tortilla Soup. If you are a father with daughters or are a daughter, you absolutely have to see it. Be prepared to leave smiling.

I am off to Bermuda tomorrow morning for a hedge fund conference. I will report next week on the mood and thoughts of this gathering of some of the largest and savviest traders in the world. If you are an accredited investor, and would like to read my e-letter on hedge funds and private offerings, write to me or call Wayne Anderson at my office (800-829-7273) and we will email you the form to get on the list. (Sorry, securities regulations make me limit this letter to accredited investors. I wish the rules were different.)

Have a great week, and remember that we will be in that second half recovery before you know it. Opportunities of a lifetime await us. Patience. Time flies, so enjoy the trip.

Now if only I could get my golf scores to deflate without using the pencil wedge.

Your enjoying his journey through life analyst,

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