The End of an Era

2008 marked the end of an Economic and Political Era. The Reagan Era that just ended had several important characteristics:

1) Financial Innovation and higher debt levels. (more leverage)
2) Good demographic trends
3) Increasing consumer spending
4) Strong International Trade
5) Strong Global Economic Growth
6) Relative Political Stability

By contrast the new era we are entering may have the following characteristics:

1) Liquidation and lower debt levels (less leverage)
2) Negative demographic trends
3) Higher consumer savings
4) International trade limited
5) Weak to negative global economic growth
6) Political Instability

The Reagan Era started in the 1980s with the Reagan Revolution and a change in the regulation of the financial sector. The Reagan Era has seen a large increase in the flexibility of the financial system. In this Era the financial system created so much flexibility that many projects that otherwise would not be built, were able to find financing. But, the creative financial instruments became too fragile to withstand an economic downturn. This era ended with the failure of many sub-prime mortgages and related financial derivatives. The sub-prime mortgages were not the only asset class impacted by these factors, but just the first. Almost every type of asset was securitized in some way. The securitization of assets allows a much higher leverage and a higher price for the underlying asset. Thus, you had home prices rising to very high levels because of the securitization of mortgages. But with all the Wall Street firms becoming commercial banks, this unregulated activity is coming to a swift halt. The amount of securitization is falling rapidly and with new regulations on the horizon, the size of the market will be significantly smaller than in the prior years.

Besides the increase in asset prices, a second impact of the securitization was an increase in leverage. By allocating the risk of a security to different people, loans that otherwise would not be possible, become commonplace. Thus, the total amount of lending increased and total leverage increased. Many people, firms and banks found the advantages to leverage. When you borrow money you can gain huge personal profits by investing the money at higher rates of return than the interest rate. But if the economy faces some road bumps, you can go bankrupt. When everyone faces the same road bumps, the result is a severe recession. The more leverage in the system the higher the profits in good times AND the higher the losses in the bad times. Thus, the higher leverage has created a deeper and longer recession than lower levels of leverage would have created. In the new Era, the higher cost of leverage will be a factor in the slower growth and slower recovery from the recession.

Yet financial innovation was not the only key factor in the Era. Demography and increased consumer spending were very important. Some age groups spend more on things and save less than other age groups. For example, people in their late twenties and thirties are building households and tend to spend far more than other age groups on household items. People in their fifties tend to save for retirement and already have a household. Thus, the amount of consumer spending per capita is dependent on both the society’s culture and the age profile. Look at the age profile for the 1990’s:


You can see the bulge of people in their late twenties and early thirties.
Now compare that to the profile from 2015:

See the dramatic increase in 50-60 year old people?  They have different amounts of consumer spending than the 25-35 age group.   In addition, the culture may have hit a point were conspicuous consumption is less desired.  Overall, consumer spending will fall and savings will rise.

Other key factors were the lowing of trade barriers and the increasing global growth.   Both of these added significantly to the GNP of India, China and other countries outside the “First World”.  But with the economic slowdown and lower consumer spending in the US, the world trade and economic growth is under fire.  While we don’t know how much trade will be restricted, the NAFTA has come under attack and China is likely to feel the pressure of the environmental movement.  The trend of free trade has been reversed and will result in lower global economic growth.

Lastly, if global economic growth slows, then more countries will face political instability.  Recently the Baltic States have had riots and other signs of political instability.  With a global recession just starting, the pressure on many countries will be enormous.  This will in turn feed less economic growth around the world and higher prices for goods and services. 

While the extreme of the Roaring Twenties and the Depression of the Thirties may not occur, the Reagan Era will be followed by an Era of recession and low economic growth.   Adjusting the system for the new levels of leverage will take time.  This new Era may last 10 years, but could last longer.

The Debate between Inflation and Deflation

The money supply and many measures of monetary aggregates have increased in a dramatic way in the past couple of months. This increase has some people concerned about inflation and predicting a strong showing in gold. But the data show a real problem with the velocity of money. This change in velocity of money is significantly stronger than the change in money supply. The result will be a deflationary environment and gold and other commodities will not be good investments.

A quick review of basic Macro-Economics is in order. First, recall from Econ102 that the GDP equals the money supply times the velocity of money. Often the velocity of money is called the money multiplier. In a practical sense, if you have a $20 bill and spend it very fast and the retailer also spends it very fast, that one $20 bill can circulate to many times in one year. So that one $20 bill can be in say 100 transactions in a year. Or $20,000 of GDP is attributable to that one $20 bill. Now in our simple example we decide the economy is bad and we want to save that $20 bill. We put it in our wallet and don’t spend it for several months. Now that $20 bill may only be attributable to 10 transactions a year or $2,000 of GDP. If the US economy is not to drop from $20,000 to $2,000, then the money supply must increase. And increase in a dramatic way. Thus, GDP has to equal the money supply multiplied by the velocity of money. While this is a very simple example, it shows the point. If the velocity of money suddenly falls, then the money supply must increase or a large decrease in GDP will occur. After some math, the equation can be stated as: inflation is equal to the rate of money growth, plus the change in velocity, minus the rate of output growth.

In the past few months the money supply (M2) has increased. In the chart below notice the large increase in M2 in the past couple of months. So many are worried about inflation.


But this worry is misplaced and wrong at the present time. WHY? Because the velocity of money has crashed! For the first time since the Great Depression people dramatically decreased the pace they used money. This decrease in velocity is seen the in the following chart:



The velocity of money has fallen off a cliff! This is really important because of the multiplier effect. This means for GDP to stay constant, we need 50% more money, because in a very short time velocity has fallen 50%. This Money Multiplier chart shows that until the velocity of money increases, then the money supply needs to double NOW.

Going back to our simple formula, the money supply in one year has grown 9.5%, the velocity of money is -40.1%. This means that prices or output (YOY) must fall 31.4%! Even if output falls 10%, deflation would be 21.4%. The data for the velocity of money are STUNNING. The Federal Reserve is trying to increase the money supply in a dramatic way, but the concern is it will not be able to judge the correct amount of money to try to create. If the velocity of money numbers are correct, then they are not increasing the money supply at a fast enough pace to prevent a major deflationary period.

The concern of many that inflation may result will be true IF the velocity of money suddenly jumps back to it’s previous levels. But until the velocity of money increases, we will be in a DEFLATIONARY environment. Hard asset prices will fall and interest rates will stay low. At some point, inflation may explode, but NOT until the velocity of money returns to somewhere near it’s previous values.

Why the bailout of GM and Chrysler was bad.

Quite simply the Bush Administration did not solve anything. Instead they acting in a defensive way and decided to punt. They gave the automakers enough money for a couple of months and now the Obama Administration has to decide what to do. The simple fact is they should have let them go into bankruptcy. It would have been better for the country in the long run.

But what about all the auto workers and other people in the auto industry? Dramatic changes have to occur in the auto industry. The industry in the US has been very sick for many years. The recent events have just pushed them over the edge and are not a temporary state of affairs. If the problem were temporary or one-time, a bailout would have been a good plan. But the fundamental problem is the US auto industry has not been competitive for many years. How do you get people to change? Unfortunately the only way to get millions of people to change is a very dramatic action. It takes a bankruptcy to really force change on management and the blue collar workers. Without bankruptcy the management stays the same (note the President of GM is not resigning) and the auto workers are also not changing. More importantly while the culture of Detroit is under pressure, it will not change without bankruptcy. You have to change a culture that has produced such a string of lemon cars.

In the past few months it has become clear many people don’t understand the capitalist system. The simple fact is humans make mistakes. How do you get them to change and stop making the mistakes? The capitalist system forces people who do not provide a good product at a reasonable price into bankruptcy. The capitalist system is not touchy-feely, but brutally honest. If you don’t have the goods, you fail. Many people don’t like this feature of capitalism. But it is critical for an economy and a society to dump the process or products that don’t meet a need. The Soviet system was great at producing products, but many people did not want them! Just producing cars or any product without regard to style, cost and reliability has to be stopped. The capitalist system uses bankruptcy to FORCE changes. When a government steps in and limits change, they harm the economy and the future economic growth.

The Recent Fed Announcement

The Federal Reserve has come out with an incredible announcement. (see http://online.wsj.com/mdcapp/public/page/2_3024-info_fedparse_shell.html) While the headline number of 0 to 25bps interest rates that banks can borrow is important and unusual, it is not the heart of the release. What is dramatic is that the Fed is going to target longer term interest rates. While I am not a macro economist, this is going to be interesting to see if they can achieve such targeting.

The problem is that to drive interest rates lower, they must purchase long-dated loans by printing money. At some point, the amount of money in the system will increase prices. At that point, any investor who purchases say 10-year treasuries is going to receive far less money than the original principle. For example, you buy $1 million of 10-year treasuries. Inflation increases by 10% per year in the very last year. All other years inflation is zero and the interest rate is 3%. That means for nine years you get 3% rate of return and the last year you get a negative 7%. That is not a good investment and you will suffer a loss (if not in raw cash, in a net present value sense.) Thus, the idea that the Fed can control long rates is questionable. In the entire history of the world, no central bank has been able to control long rates for more than very short (weeks) periods of time. At some point the very act of trying to control long rates is counter-productive.

What conclusions can you reach about the FED statement? They are really worried. They are throwing everything including the kitchen sink into the fight. They are using every bullet they have and are borrowing a few from others! What happens if something else happens? What else can the FED do? THey have used everything to fight the current battles and they are risking something even more important- their credibility. If the economy does not respond quickly, their might be a really significant fall in the stock market as there is nothing left for the FED to do. As more than a few people have said: They are ALL IN. Nothing left to do but execute. That has to be scary for every investor.

Why Natural Gas will not go below $4 MCF.

1) Natural gas supply from Canada is falling and will continue to fall for the next few years. Until the BC shale play gets pipe, it will fall a bcf or more in 2009. Look at the past several years and you can see the decline WITH a great natty price. In the meantime, Alberta has significantly increased taxes, the overall price has fallen and costs have skyrocketed. According to market analyst Martin King of FirstEnergy
Capital, "at current prices, little in the way of new natural gas
production is economic in Western Canada." As a result every player is reducing cap ex by 30-50%. This will decrease production by a significant amount (10%?)

2006 2007 2008 2009
Oct 17.21....16.71....16.18 15.?

2) If the price is low, LNG will continue to be low. Several simple cost addition show you need a price well above $5 for LNG to be economic. In other words, the cost of transporting and getting the LNG to natty costs about $4+. With a price below $5, it does not pay anyone to ship the gas.

3) For some reason electric generation has been killed this fall. This is giving many a signal that the natty market is oversupplied. But a decrease in demand for natty from generation is likely to be temporary. All signs point towards more electricity being used in transportation and other energy sources. Coal will be 'killed' by new co2 regulations at the very time electric demand will increase. Thus, to argue that electric demand is going to continue to be lower than normal is risky.

4) Demand is a concern in a recession. Fertilizer and other products that use natural gas are clearly decreasing output. As a result the demand for natty is going to be down YOY ignoring weather. Thus, the price of natty will be down from lower demand.

5) THE BIG ONE: Supply from the new shales. Everyone agrees that the new technologies have increased production from unconventional sources. But several important factors limit the amount of production increase in 2009:
a) Pipelines- EOG's Papa has argued strongly that pipeline capacity is going to limit production increases. You have to have pipelines to deliver the gas to markets. When you are talking about a bcf a day, that requires a lot of pipe. Many have ignored the huge constraint in production of pipelines.
b) Credit: With out credit, many shale producers are scaling back ALL capital expenditures. Look at CHK's dramatic decrease in cap ex. The leasing prices have fallen through the floor. Once the current leases get developed, production levels will fall. But even more important to the short run projection is the lack of credit to drill all the current leases. In order to drill all the wells, significant capital must be in place (local pipelines, processing equipment etc). The net call on cash will be too great for all but the largest operators.
c) Why produce a well now at <$6 mcf, when you can wait and produce it later? With a clear economic signal that we have enough natural gas, many producers will delay drilling for better prices. Many leases are held by production or are so expensive, it may pay to drop or re-lease.
d) Permits and other government approvals will be more difficult. With the new administration, any permits not granted by Jan 20, will be at the least delayed and at the extreme rejected. Colorado is going to see a large decrease in drilling because of permits. Even if you have all of the previous comments covered, you have to have a permit. That is not going to be easy after Jan. 20th.

From all of these factors, drilling after the 20th of January is going to drop significantly from prior years levels. I would not be surprised to see 750+ less rigs drilling for natural gas than last year. At that rate, depletion of 15%+ will have an impact on production.

Of course, if we get a very warm winter, then prices can go below $4. But with a reasonable winter, prices will not be less than $4.

What are some early indicators that the economy is starting to turn around?

It may be too soon to look at the economy turning around, but everyone wants to know what to look at. What data points will show the economy has hit bottom and starting to rebound?

1) Delinquency rates on home loans falls. The delinquency rates are reported by several sources and should be one of the first indicators that the economy has bottomed. When the delinquency rate actually falls, the economy may shortly hit bottom. But if the delinquency rate is rising, more pain will surly follow.

2) Electric generation has to increase by a nice percentage. One of the key indicators in a service economy is electric generation. If people are using lot's of new computers or making things, it will require electricity. So on a weather adjusted basis, electric generation needs to increase at a nice pace.

3) Private Employment shows a good positive growth. While the unemployment number grabs the headlines, one key growth indicator is a good increase in the overall number of jobs. During the current recession the actual number of jobs should fall. When we see the number of PRIVATE jobs (excluding the public sector) go up, then a recession may have hit bottom.

4) A new industry takes off. By it's very definition you cannot predict what the new growth industry will be, but every downturn has a NEW industry leader. While it can be an old industry, it has to have reinvented itself. Just a bigger or newer adjustment is not enough. It must be a radical change from the past. I have no idea what this will be, but it will be the best investment opportunity anyone can make.

5) Inflation returns and interest rates on Treasury bills increase. Without some inflation, the money supply may actually be falling. Thus, given the large government deficits, without a good amount of inflation, the economy is still very very sick.

6) The VIX falls. Stock market volatility is a sign the market has no clue what is going to happen. Until the market settles down, there can be no bottom in the economy. The longer the stock market is going up and down by 5oo points a day, the longer the recession will be. I would like to see the VIX back to historical norms before we can even talk about a real economic recovery.

While there may be other indicators, this is a good start. International economy is different and the following are some indicators:

1) Internationally, the Baltic Freight Index is a key indicator. Until this rate increases from it's current record lows, international trade is low and a severe drag on the world economy. Clearly the amount of new ships will impact the rate, but until the rate rises to a break even cost level, the world economy will be in recession.

2) The price of oil. Until the price of oil goes above $75, we are in a world recession.

3) The price of copper and other metals. Without an increase in metal prices, the world economy is in a recession.

Given the lower economic level of most of the world, the more traditional measures of economic activity will show the world's economic progress.

With these indicators as a start, everyone can look for signs of the economic turnaround. But I am not optimistic the signs will appear in the 1st half of 09.