Showing posts with label John Maudlin. Show all posts
Showing posts with label John Maudlin. Show all posts

Friday, September 26, 2014

Are you a "Future Bull"?

By John Mauldin

In a conversation this morning, I remarked how rapidly things change. It was less than 20 years ago that cutting edge tech for listening to music was the cassette tape. We blew right past CDs, and now we all consume music from the cloud on our phones. Boom. Almost overnight.

A lot has changed about the global economy and politics, too. Things that were unthinkable only 10 years ago now seem to be reality. What changes, I wonder, will we be writing about a few years from now that will seem obvious with the advantage of hindsight?

In today’s Outside the Box, my good friend David Hay of Evergreen Capital sends us a letter written from the perspective of a few years in the future. I find myself wishing that some of the more hopeful events he foresees will come true, and my optimistic self actually sees a way through to such an outcome. In that future, I will join David as a bull. But the path that he proposes to take to that more optimistic future is not one that most investors will enjoy, so on the whole it’s a very sobering letter and one that should make all of us think.

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I’m back from San Antonio, where I spent four enjoyable days with my friends and participants at the Casey Research Summit. I tried to attend as many of the conference sessions as I could, and I intend to get the “tapes” for some of the ones I missed.

I did a lot of video interviews while in San Antonio, too. And finished up a major documentary. Mauldin Economics will be making all of these available very soon. It’s hard to recommend one interview over another, but Lacy Hunt is just so smart.

And with no further remarks let’s turn it over to David Hay and think about how the next few years will play out. Have a great week.

Your wishing his crystal ball was clearer analyst,
John Mauldin, Editor

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Future Bull

By David Hay
Twitter: @EvergreenGK

“Money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong.”
– Economist and historian Niall Ferguson

Future bull.  Let me admit up front that this EVA has been rolling around in my mind for quite awhile. Its genesis may be directly related to the fact that I’ve been desperately yearning to write a bullish EVA – besides on Canadian REITs or income securities that get trounced by the Fed’s utterances. In other words, I want to return to my normal posture of being bullish on the US stock market.

It wasn’t long ago, like in 2011, that clients were chastising me for believing in what I formerly referred to as “the coiled spring effect.” By this I meant that corporate earnings had been rising for over a decade, and yet, stock prices were much lower than they there were in 1999. Consequently, price/earnings ratios were compressed down to low levels, though certainly not to true bear market troughs. My belief was that stocks were poised for an upside explosion once the inhibiting factors, primarily extreme pessimism on the direction of the country, were removed. I even remember one long-time client dismissing my “Buy America” argument on the grounds that in my profession I had to be bullish (regular EVA readers know that is definitely not the case!).

Well, a funny thing happened to my “coiled spring effect” – namely, it became a reality. Additionally, the upward reaction was much stronger than I envisioned. But what really caught me by surprise was that it played out with virtually no improvement on the “extreme pessimism on the direction of the country” front. Perhaps I’m wrong, but I don’t think there has ever been a rally that has taken stocks to such high valuations (time for my usual qualifier – based on mid-cycle profit margins, not the Fed-inflated ones we have today) concurrent with such pervasive fears America is on the wrong track.

Undoubtedly, the pros among you who just read that last sentence are thinking: “That’s great news! All that pessimism will keep this market running. We’re not even close to the peak.” Not so fast, mon amis (and amies)! We’re not talking market pessimism here. As numerous EVAs have documented, US investors are as heavily exposed to stocks as they have ever been, other than during the late 1990s, when stocks bubbled up to valuations that made 1929 look restrained.

Further, please check out the chart below from still-bullish Ned Davis regarding investment advisor sentiment.  The bearish reading is the lowest since the fateful year of 1987, while bulled-up views are in the excessively optimistic zone.  (See Figure 1.)



It is my contention that there are currently millions of fully-invested skeptics. They aren’t bullish long-term – in fact, they believe the underlying fundamentals are alarming (with the usual perma-bull exceptions) – but they feel compelled by the lack of competitive alternatives to remain at their full equity allocation.

Disturbingly, professional investors are increasingly doing so even with money belonging to retired investors who need both cash flow and stability.

Okay, with all that history out of the way, let’s go the other direction  – into the future, to a time several years from now, when conditions are nearly the polar opposite of where they are today.

The Evergreen Virtual Advisor (EVA)

November, 201???

At long last, reforms! Do you remember back in 2014 when the stock market was as hot as napalm? When it just never went down? When millions believed the Fed could control stock prices by whipping up a trillion here and a trillion there?

Looking back from the vantage of today, it all seems so obvious. We should have known better than to believe that the S&P 500 had years more of appreciation left in it after having already tripled by the fall of 2014 from the 2009 nadir. The warning signs were there. But, before we rehash what went wrong, let’s focus on the upside of what some are calling “The Great Unwind” – the hangover after years and years of the Fed recklessly driving asset prices to unsustainable heights.

First of all, let me start with what I think is the biggest positive of all:  the end of the central banks’ era of omnipotence. While that might sound like a major negative, you may have noticed that with the crutch of binge-printing taken away, our nation’s leaders are finally getting around to implementing reforms that should have been enacted years ago. The history of our country is that we are energized by crises, and the latest is no exception. Our most recent financial convulsions have galvanized a bipartisan coalition to attack an array of long-festering problems that have hobbled our country since the start of the millennium.

Arguably, the most important was the recently enacted tax reform legislation. Skeptics believed the US could never move toward the type of simple tax system that has long been used in countries like Singapore, Hong Kong, and even Estonia. It took the realization by both parties that lower tax rates with almost no deductions would actually produce more revenue. Moreover, the elimination of incalculable and massive “friction costs” for millions of businesses and individuals, trying to adhere to and/or game that beastly labyrinth known as the tax code, is quickly catalyzing real economic growth. This is in contrast to the 2010 to 2014 counterfeit version that rolled off the Fed’s printing press.

By 2014, the US was ranked a lowly 32nd out of 34 countries in terms of tax fairness and efficiency. Yet, now, thanks to last year’s drastic tax reform, US corporations are no longer fleeing in droves to other countries, using such tax dodges as inversions (buying out foreign companies and assuming their country of corporate citizenship to access lower tax rates). They have even begun to repatriate their trillion or so of offshore profits since the formerly onerous tax rate of 35%, the highest in the developed world, has been reduced. And, thanks to the eradication of the aforementioned legalized tax dodges, corporate tax receipts are actually beginning to rise sharply, despite the fact that our economy is in the early stages of recovering from the latest recession.

As we all know, the rationalization of our national business model involves much more than even the essential aspect of tax code simplification. At long last, meaningful tort reform has been enacted. No longer will the rule of lawyers be allowed to dominate the rule of law. The enormous, but insidiously hidden, costs of a subsector of the legal system whose chief mission is to squeeze unjustifiable sums from the private sector is finally being reined in.

Similarly, regulatory overkill is also being addressed by the very entity that created this monster in the first place: the government itself. Absurd, overlapping, and often conflicting directives that hobbled the most essential element of the private sector – small businesses – have been abolished, replaced by a much simpler and unified set of rules.

Even America’s dysfunctional and wasteful healthcare system is being revamped using rational economic solutions, rather than by piling on more incomprehensible rules, requirements, and panels. Consumers can now easily compare prices among service providers thanks to technology as instituted by for-profit providers. Along with significantly improved visibility, they also now have far greater control over how their healthcare dollars are spent.  Medical outlays are now in a decided downtrend.

Incredibly, Congress is actually beginning to behave like a representative of the people rather than an ATM dispensing taxpayer money to the most politically connected. The intense implosions of the multiple bubbles the Fed intentionally inflated triggered a backlash of voter ire toward its legislative enablers. Since then, we’ve seen a dramatic House – and Senate – cleaning. This new “coalition of the thinking” is now following the proven path to recovery that numerous countries – such as Germany, Sweden, and Canada – blazed when their economic and financial systems hit previous roadblocks. As in those nations, moving away from excessive socialism, while simultaneously supporting the business community, rather than vilifying and hindering it, is already beginning to elevate America out of its long stagnation.

Collectively, these sweeping reforms are as dramatic as those seen in the 1980s and promise to unleash a growth boom equally as powerful as the ones that followed those overhauls. Yet, despite these dramatic and highly promising changes, investors remain hunkered down in their bomb shelters.

Fool me once, fool me twice, fool me thrice!  After the third devastating bear market since 1999, investor hostility toward stocks has reached a level unseen since the 1970s. Far too many were lured in by the last up-leg of the great bull market that started in the depths of pessimism in March of 2009. As the market resolutely climbed higher and higher, even beyond the five-year length of most bull cycles, millions of investors succumbed to either greed or complacency.



Indicative of the feverish conditions prevailing then—despite the widely disseminated myth that it was the most hated bull market of all time—headlines like those shown below, and graphics such as the one above, began to dominate the financial press.



Remarkably, at least to me, investors once again ignored warnings from the savviest savants, almost all of whom had waxed cautious about the tech and housing manias: Bob Shiller, Jeremy Grantham, Rob Arnott, John Mauldin, Seth Klarman, and John Hussman. As the esteemed Mohamed El-Erian had prophetically written in June of 2014, “In their efforts to promote growth and jobs, central banks are trading the possibility of immediate economic gains for a growing risk of financial instability later.”

Conversely, Janet Yellen didn’t do her legacy any favors by uttering these words in July, 2014: “Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical.” At the time, I was pretty sure she would come to regret that statement as much as Ben Bernanke did his equally ill-advised assurances back in 2007 that the problems in sub-prime mortgages were contained. Based on how fragile the “resilient financial system” turned out to be, I’ll say no more.

It did surprise me that despite having called out those previous bubbles, as well as several others including the 2008 blow-offs in commodities and Chinese stocks, I received such intense resistance from other professionals and even clients. After awhile, I was getting so much push back I started to feel like the nose of a commercial airliner being readied for take-off.

Ignorance wasn’t bliss. Another aspect of the late stages of the last bull market was how many investment professionals – who should have known better – dismissed Robert Shiller’s namesake P/E. To clarify, Shiller believes (as did Warren Buffett’s mentor, Ben Graham) that the stock market needs to be valued based on normalized earnings, not bottom- or top-of-the cycle profits. Despite the unassailable logic of this approach, a legion of perma-bulls repeatedly sought to discredit Shiller and his valuation methodology. Some even went so far as to deride his process as “Shiller Snake Oil,” notwithstanding Dr. Shiller’s Nobel Prize and, more meaningfully in my view, the fact that he had forewarned of both the tech and housing bubbles – unlike almost all of those throwing stones at him back in 2014.

The main criticism from those who were “hatin’ on” Shiller in 2014 was that his P/E had produced only two buy signals over a 25-year period. This was a valid critique but it missed an essential point: Despite the reality that the stock market from 1990 to 2014 traded at valuations far higher than it had in any previous quarter-century timeframe, the Shiller P/E accurately predicted future returns. In other words, when the Shiller P/E was very elevated – like in the late 1990s, 2007, and 2014 (so far) – stocks went on to generate extremely disappointing future returns (it also did so in decades going all the way back to the 1920s but this was not the era that the Shiller debunkers were criticizing). The graphic on the next page vividly illustrates this fact, even though it was created before the most recent bear market further underscored the danger of ignoring high Shiller P/Es. (See Figure 2.)



It also shocked and dismayed me at the time how many contortions Wall Street strategists, and even money managers, performed in order to dismiss concerns about the extreme variability of earnings. Somehow charts like the one below from Capital Economics were blown-off despite (or, perhaps, because) it so clearly highlighted the tendency of corporate profits to return back down to the long-term trend-line of nominal GDP growth, with stocks closely following. As we all now know, this time wasn’t different. (See Figure 3.)



The legions of market cheerleaders also ignored the heavy reliance on profits from the financial sector, a notoriously unstable source of earnings. This proved to be a disaster in 2007 and, unsurprisingly, was again once the Fed’s “Great Levitation” fell victim to gravitational forces. (See Figure 4.)



Even David Rosenberg, one of the few economists who saw the housing debacle coming, but who briefly flirted with drinking the Fed-spiked bubble-aid in 2014, noted that 60% of earnings growth from 2010 through 2013 came from share buy-backs. He calculated that the market’s “organic” P/E, backing out the influence from share repurchases, was over 20, even prior to normalizing for peak profit margins. Additionally, the reality that corporations buy the most stock at high prices, and the least at low prices, was forgotten – another costly oversight. (See Figure 5, above.)

It was also overlooked during this era of Fed-induced euphoria, that low interest rates – so often cited by bulls as a justification for lofty P/Es – historically coincided with lower earnings multiples. (See Figure 6.)



As Japan and Europe have repeatedly shown over the last two decades, when low interest rates are a function of chronic economic stagnation, P/Es actually contract, not expand. The fact that the latest recession has reduced America’s anemic 1.8% annual growth rate since 2000 to even lower levels is a key reason why stocks have been thrashed over the last couple of years, despite interest rates on the 10-year treasury note falling to 1%.

Another massive mistake was to overlook the strident warning from Evergreen’s favorite valuation metric, the price-to-sales (P/S) ratio. By the summer of 2014, the median stock in the S&P 500 was trading at its highest P/S ratio on record. Sadly, this attracted little attention. (See Figure 7.)



But perhaps the most egregious oversight of all was to forget the theorem from the late, great economist Hyman Minsky who long ago warned that stability breeds instability. As was the case from 2002 through 2007, the exceptionally low volatility of the years leading up to the latest crisis numbed market participants to the steadily rising risks. Even professional investors convinced themselves they could get out in time once conditions became unstable, an arrogance that has been severely punished, as well it should. Alas, we’ve had to learn Dr. Minsky’s lesson the hard way, once again.

But let’s close this EVA by focusing on the stunning opportunity for investors created by the Fed’s latest misadventure…...

Investors, start your engines! It is certainly understandable that US investors are thoroughly disenchanted with the stock market. The fact that the powers-that-be, or at least used-to-be, allowed securities trading to become so heavily dominated by computers was, like the tolerance of the Fed’s asset inflation, inexcusable. The influence of computerized, black box trading was unquestionably a huge factor in the speed-of-light-in-a-vacuum drop in stock prices. Also as feared, many ETFs poured kerosene on the fire as investors became terrified by the nearly overnight erosion in these prices, causing them to sell en masse. The plethora of ETFs holding illiquid underlying securities were particularly crushed, with many simply halting trading for long stretches. Now, instead of rapturous paeans about the wonders of ETF liquidity and low costs, the financial press is full of horror stories about their fundamental flaws (fortunately, higher quality and more liquid ETFs, performed as expected during the worst of the panic).

Further, based on the failure of the Fed’s desperate maneuver to stabilize stocks after their first big break, by launching another $1 trillion QE, this time directly buying US shares, investors have rationally lost faith in the Fed’s ability to make stocks dance to its tune. While QE 4 did cause a sharp counter-trend rally after it was initially launched, the supportive effects soon waned, as we all are now painfully aware. The resumption of the bear market after the Fed’s frantic triage effort was reminiscent of Dorothy, the Tinman, the Lion, and Toto discovering that behind the green curtain was a scared old man instead of The Wizard of Oz.

The extreme negativity by investors toward the stock market today is reflected in the high level of outflows being seen from equity mutual funds, including ETFs. Cash levels are high everywhere as institutional and retail investors, as well as corporations, have become excessively risk averse. This provides the rocket fuel for the next bull market which might just be much closer than almost everyone believes.

Rampant investor pessimism is also being manifested in the drop in the Shiller P/E to the mid-teens from 26 at the peak of the last bull romp.  As a direct result, future returns on stocks are now projected by the aforementioned Jeremy Grantham and John Hussman to be in the low double digits over the next seven to ten years.  Yet, no one seems interested. Even Warren Buffett’s ragingly bullish comments, which were considerably premature, are being attributed to the ramblings of a soon-to-be nonagenarian.

Naturally, I have considerable empathy for Mr. Buffett because, as usual, Evergreen was early to shift into bullish mode. We waited much longer than most people and actually did a fairly commendable job of cutting back into the Fed’s QE4 driven rally, after raising our equity exposure during the initial steep sell-off. But once stocks fell hard after that sugar-high wore off, we were guilty of our typical “premature accumulation syndrome.”

However, we did the same thing way back in October of 2008 when we published our client newsletter, “A Bull is Born” (and wrote a series of “buy the panic” EVAs), only to watch the market slide another 30%.  Yet, buying when almost the entire world was in liquidation mode, much of it forced, in the fall of 2008 proved to be extremely lucrative over the next two years. We are convinced the same will be true following this latest episode of market mayhem.

From a longer-term standpoint, a perspective most investors seem unwilling to take given their still-fresh pain and suffering, conditions look highly encouraging. In addition to the previously described remedies our policy makers are belatedly adopting, many of the key positive trends the bulls used to justify over-the-top valuations for stocks back in 2014 are still in place. Admittedly, the enthusiasm got ahead of reality but the energy renaissance continues apace in the US, despite the well-publicized fracking problems. Re-shoring of manufacturing, which has been slower than the uber-optimists forecast, appears to be now accelerating. Relatedly, robotic adoption is rapidly spreading through the US industrial base, supporting Evergreen’s belief that re-shoring is a reality, not a fantasy. Yet, there’s even more to like.

Nanotechnology and solar power innovators continue to provide breathtaking breakthroughs. Today, nanotech is becoming as ubiquitous as the microprocessor was a decade ago. Meanwhile, solar power, thanks to miniaturization advances similar to Moore’s Law, has achieved “grid parity,” or even lower, in over a dozen US states. Power is becoming increasingly cheap and abundant and that’s terrific news for humanity.

Finally, and perhaps most significantly, we are far closer to achieving that wondrous, if slightly scary, state known as “singularity.” As most us now know, this means that humans are becoming one with computers.

The proliferation of wearables has essentially elevated the intelligence of anyone who can afford to spend $150 for an iWatch or Google Glass, to the level of a supercomputer. We now take for granted being able to whisper a few instructions into our watches, like Dick Tracy, and have all the information of the Cloud at our disposal. (It may soon be feasible to actually have a computer implanted into our brains, possibly even curing Alzheimer’s.) Clearly, the implications for productivity are nearly limitless. Already, we are beginning to see this in the data and we believe we are in the very early innings of a true revolution – with no apologies to gloomsters like Northwestern University’s Robert Gordon who believed, and still do, that the era of radical innovation ended long ago.

One of the biggest challenges a professional investor faces is the tyranny of current prices. When they are relentlessly rising, as they were back in 2013 and 2014, clients extrapolate those indefinitely, and, for a long time, they are right to do so. The same thing happens on the downside in periods such as we are in right now.  But rising markets always turn down and falling ones always turn up. Those are unquestionable facts. We are getting closer to the point where this bear goes back into its cave for a nice long nap while a powerful young bull is ready to bust out of the pen it’s been cooped up in for what seems like an eternity. Get out your checkbook – it’s time to bet on the bull!

Back to the here and now. A wise man once said that if you are going to predict that something will happen, don’t be so foolish as to say when it will happen. You may have noticed, I’ve followed that advice, perhaps to an irritating degree, mainly because I truly have no clue when our current bull market, already so long in the horns, will succumb.

It also goes without saying, but I will anyway, that the sequence and details of future financial events are almost certain to be dramatically different than what I’ve suggested in this EVA edition. However, I believe the broad outline is likely to be roughly along these lines, including my exceedingly optimistic long-term outlook for America.

It dawned on me as I wrote the section about tax, tort, healthcare, and regulatory reforms that many readers were probably thinking: “Not in my lifetime – and I’m only 50!” First, of all, let me say that I’m jealous you’re just 50. Second, it is highly unlikely stocks will remain in a long-term bull market, or even continue to hover at such generous valuations, unless our country makes some truly dramatic changes. It can’t remain business as usual, persistently avoiding essential reforms, relying almost totally on the Fed.

Believe me, I will be a bull again, and likely a very lonely one at that. But it’s going to take a combination of lower valuations and a serious makeover of how this country operates. We can do it and I’m convinced we will do it. Hopefully, I’ll be able to convince some of you the next time fear is on the rampage.


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The article Outside the Box: Future Bull was originally published at mauldineconomics.com.


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Tuesday, September 23, 2014

Where's the Growth?

By John Mauldin



In 1633 Galileo Galilei, then an old man, was tried and convicted by the Catholic Church of the heresy of believing that the earth revolved around the sun. He recanted and was forced into house arrest for the rest of his life, until 1642. Yet “The moment he [Galileo] was set at liberty, he looked up to the sky and down to the ground, and, stamping with his foot, in a contemplative mood, said, Eppur si muove, that is, still it moves, meaning the earth” (Giuseppe Baretti in his book the The Italian Library, written in 1757).

Flawed from its foundation, economics as a whole has failed to improve much with time. As it both ossified into an academic establishment and mutated into mathematics, the Newtonian scheme became an illusion of determinism in a tempestuous world of human actions. Economists became preoccupied with mechanical models of markets and uninterested in the willful people who inhabit them….

Some economists become obsessed with market efficiency and others with market failure. Generally held to be members of opposite schools – “freshwater” and “saltwater,” Chicago and Cambridge, liberal and conservative, Austrian and Keynesian – both sides share an essential economic vision. They see their discipline as successful insofar as it eliminates surprise – insofar, that is, as the inexorable workings of the machine override the initiatives of the human actors. “Free market” economists believe in the triumph of the system and want to let it alone to find its equilibrium, the stasis of optimum allocation of resources. Socialists see the failures of the system and want to impose equilibrium from above. Neither spends much time thinking about the miracles that repeatedly save us from the equilibrium of starvation and death.


And to that stirring introduction let me just add a warning up front: today’s letter is not exactly a waltz in the park. Longtime readers will know that every once in a while I get a large and exceptionally aggressive bee in my bonnet, and when I do it’s time to put your thinking cap on. And while you’re at it, tighten the strap under your chin so it doesn’t blow off. There, now, let’s plunge on.

Launched by Larry Summers last November, a meme is burning its way through established academic economic circles: that we have entered into a period of – gasp! – secular stagnation. But while we can see evidence of stagnation all around the developed world, the causes are not so simple that we can blame them entirely on the free market, which is what Larry Summers and Paul Krugman would like to do: “It’s not economic monetary policy that is to blame, it’s everything else. Our theories worked perfectly.” This finger-pointing by Keynesian monetary theorists is their tried and true strategy for deflecting criticism from their own economic policies.

Academic economists have added a great deal to our understanding of how the world works over the last 100 years. There have been and continue to be remarkably brilliant papers and insights from establishment economists, and they often do prove extremely useful. But as George Gilder notes above, “[As economics] ossified into an academic establishment and mutated into mathematics, the Newtonian scheme became an illusion of determinism in a tempestuous world of human actions.”

Ossification is an inherent tendency of the academic process. In much of academic economics today, dynamic equilibrium models and Keynesian theory are assumed a priori to be correct, and any deviation from that accepted economic dogma – the 21st century equivalent of the belief by the 17th century Catholic hierarchy of the correctness of their worldview – is a serious impediment to advancement within that world. Unless of course you are from Chicago. Then you get a sort of Protestant orthodoxy.

It’s About Your Presuppositions

A presupposition is an implicit assumption about the world or a background belief relating to an utterance whose truth is taken for granted in discourse. For instance, if I asked you the question, “Have you stopped eating carbohydrates?” The implicit assumption, the presupposition if you will, is that you were at one time eating carbohydrates.

Our lives and our conversations are full of presuppositions. Our daily lives are based upon quite fixed views of how the world really works. Often, the answers we come to are logically predictable because of the assumptions we make prior to asking the questions. If you allow me to dictate the presuppositions for a debate, then there is a good chance I will win the debate.

The presupposition in much of academic economics is that the Keynesian, and in particular the neo-Keynesian, view of economics is how the world actually works. There has been an almost total academic capture of the bureaucracy and mechanism of the Federal Reserve and central banks around the world by this neo-Keynesian theory.

What happens when one starts with the twin presuppositions that the economy can be described correctly using a multivariable dynamic equilibrium model built up on neo-Keynesian principles and research founded on those principles? You end up with the monetary policy we have today. And what Larry Summers calls secular stagnation.

First, let’s acknowledge what we do know. The US economy is not growing as fast as anyone thinks it should be. Sluggish is a word that is used. And even our woeful economic performance is far superior to what is happening in Europe and Japan. David Beckworth (an economist and a professor, so there are some good guys here and there in that world) tackled the “sluggish” question in his Washington PostWonkblog”:

The question, of course, is why growth has been so sluggish. Larry Summers, for one, thinks that it’s part of a longer-term trend towards what he calls “secular stagnation.” The idea is that, absent a bubble, the economy can’t generate enough spending anymore to get to full employment. That’s supposedly because the slowdowns in productivity and labor force growth have permanently lowered the “natural interest rate” into negative territory. But since interest rates can’t go below zero and the Fed is only targeting 2 percent inflation, real rates can’t go low enough to keep the economy out of a protracted slump.

Rather than acknowledge the possibility that the current monetary and government policy mix might be responsible for the protracted slump, Summers and his entire tribe cast about the world for other causes. “The problem is not our theory; the problem is that the real world is not responding correctly to our theory. Therefore the real world is the problem.” That is of course not exactly how Larry might put it, but it’s what I’m hearing.

Where’s the Growth?

It’s been more than five years since the global financial crisis, but developed economies aren’t making much progress. As of today, the United States, Canada, Germany, France, Japan, and the United Kingdom have all regained their pre-crisis peaks in real GDP, but with little else to show for it.



Where orthodox neo-Keynesian policies like large-scale deficit spending and aggressive monetary easing have been resisted – as in Japan years ago or in the Eurozone debtor countries today – lingering depressions are commonly interpreted as tragic signs that “textbook” neo-Keynesian economic policy could have prevented the pain all along and that weak economic conditions persist because governments and central banks are not doing enough to kick-start aggregate demand and stimulate credit growth at the zero lower bound.

In places like the United States and Japan, where neo-Keynesian thought leaders have already traded higher public debt levels and larger central bank balance sheets for unspectacular economic growth and the kinds of asset bubbles that always lead to greater instability in the future, their policies have failed to jump-start self-accelerating recoveries. Even in the United States, when QE3 has been fully tapered off, I would expect to see the broader economy start to lose momentum once again.

We’ve tried countercyclical deficit spending to resist recessions, procyclical (and rather wasteful) deficit spending to support supposed recoveries, and accommodative monetary easing all along the way (to lower real interest rates and ease the financing of those pesky deficits); but growth has been sluggish at best, inflation has been hard to generate, and labor market slack is making it difficult to sustain inflation even when real interest rates are already negative.

Call me a heretic, but I take a different view than the economists in charge. To my mind, the sluggish recovery is a sign that central banks, governments, and, quite frankly, the “textbook” economists (despite their best intentions) are part of the problem. As Detlev Schlichter commented in his latest blog post (“Keynes was a failure in Japan – No need to embrace him in Europe”), “To the true Keynesian, no interest rate is ever low enough, no ‘quantitative easing’ program ever ambitious enough, and no fiscal deficit ever large enough.” It’s apparently true even as debt limits draw closer.

While the academic elites like to think of economics as a reliable science (with the implication that they can somehow control a multi-trillion-dollar economy), I have repeatedly stressed the stronger parallel of economics to religion, in the sense that it is all too easy to get caught up in the dogma of one tradition or another. And all too often, a convenient dogma becomes a justification for those in power who want to expand their control, influence, and spending.

Whereas an Austrian or monetarist approach would suggest less government and a very light handle on the monetary policy tiller, Keynesian philosophy gives those who want greater government control of the economy ample reasons to just keep doing more.

Schlichter expands his critique of the logic of pursuing more of the same debt-driven policies and highlights some of the obvious flaws in the pervasive Keynesian thinking:

Remember that a lack of demand is, in the Keynesian religion, the original sin and the source of all economic troubles. “Aggregate demand” is the sum of all individual demand, and all the individuals together are not demanding enough. How can such a situation come about? Here the Keynesians are less precise. Either people save too much (the nasty “savings glut”), or they invest too little, maybe they misplaced their animal spirits, or they experienced a Minsky moment, and took too much risk on their balance sheets, these fools. In any case, the private sector is clearly at fault as it is not pulling its weight, which means that the public sector has to step in and, in the interest of the common good, inject its own demand, that is [to] “stimulate” the economy by spending other people’s money and print some additional money on top. Lack of “aggregate demand” is evidently some form of collective economic impotence that requires a heavy dose of government-prescribed Viagra so the private sector can get its aggregate demand up again.

Generations of mismanagement have left major economies progressively weaker, involving
  1. dysfunctional tax/regulatory/entitlement/trade policies created by short-sighted and corrupt political systems,
  2. private-sector credit growth encouraged by central bank mismanagement, and
  3. government expansion justified in times of crisis by Keynesian theory.
But rather than recognizing real-world causes and effects, neo-Keynesian ideologues are making dangerous arguments for expanding the role of government spending in places where government is already a big part of the problem.

We are going to delve a little deeper into this thesis of “secular stagnation” posited last year by Larry Summers and eagerly adopted by Paul Krugman, among others; and then we’ll take a trip around the rich world to assess the all-too-common trouble with disappointing growth, low inflation, and increasingly unresponsive labor markets. Then I’ll outline a few reasons why I think the new Keynesian mantra of “secular stagnation” is nothing more than an excuse for more of the same failed policies.

I think we’ll see a consistent theme: fiscal and monetary stimulus alone cannot generate “financially stable growth with full employment.” In fact, such policies only make matters worse. And funny things happen in the Keynesian endgame.

USA: Secular Stagnation or Public Sector Drag?

This latest theory – “secular stagnation” – argues that powerful and inherently deflationary forces like shrinking populations…...



… and potentially slowing productivity growth (as posited by Northwestern University professor Bob Gordon)…...



 … are adding to the deleveraging headwinds that always follow debt bubbles. According to the “stagnation” theory, structural forces have been bearing down on the natural rate of interest and weighing on the full-employment level of economic growth since the early 1980s; but the slowdown in trend GDP growth has been masked by a series of epic bubbles in technology stocks and housing.



Even before the 2008 crisis, the argument goes, the real interest rate required to restart the business cycle had been trending lower and lower for years, and the average level of growth experienced during business cycles has fallen.

Moreover, it has taken longer and longer to recoup the jobs that were lost in each of the last three recoveries.



It’s hard to argue with the data, but it’s really a matter of how we interpret it. While the five-year-old “recovery” is still the weakest business cycle in modern US history…..



… I quite frankly still believe the effects on growth are temporary. Difficult and long-lasting, for sure (as Jonathan Tepper and I outlined in our books Endgame and Code Red), but temporary nonetheless as private-sector deleveraging continues. We have encountered a massive debt crisis and still have a long way to go in dealing with the sovereign debt bubbles that are being created in Europe and Japan – with the potential of one’s ballooning out of control in the US unless we turn ourselves around.



It may take a crisis, but the forces that plague rich-world economies will eventually shake out and usher in a new era of technology-driven growth. In other words, this too shall pass… but continuing with the same old policies is highly likely to create another crisis through which we all must pass first.

Yes, shrinking workforces, private-sector debt overhangs, and technological innovation are making it difficult to achieve “financially stable growth with full employment” (quoting Summers); but governments and central banks are themselves becoming an increasing drag on rich-world economies. Our governments have saddled us with excessive public debt, onerous overregulation, oppressive tax codes, and their attendant distorted market signals; while our central banks have engaged in currency manipulation and monetary-policy overmanagement. Those in power who rely on Keynesian policies almost always find it inconvenient to cut back in times of relative economic strength (as Keynes would have had them do). And if, according to their arguments, the economy is still too weak even in periods of growth to enable the correction of government balance sheets, then perhaps their reluctance has something to do with debt piling up, market signals being distorted, and governments being empowered to encroach on every aspect of the lives of their productive citizens .

My friend Grant Williams used this chart in a speech yesterday. It shows that we have come to need ever more debt just to produce the same amount of GDP. With a deleveraging in the private sector underway, it is no wonder that growth is under pressure.



Debt is simply future consumption brought forward. Another way to think about it is that debt is future consumption denied. But there comes a point when debt has to be repaid, and by definition, from that point forward there is going to be a period of slower growth. I have called that point the Endgame of the Debt Supercycle, and it was the subject of my book Endgame.

As a result of central bank and governmental machinations, Keynesian growth is ultimately debt-fueled growth (either through the swelling of public debt via deficit spending or the accumulation of private debt via credit expansion); and eventually, public and private balance sheets run out of room to expand anymore. It has taken decades for cracks to show up in the prevailing theory, but now the cracks are everywhere.

One place where the crack-up is especially evident is Japan, where an uber-Keynesian combination of aggressive fiscal deficits and a planned doubling in the monetary base started to lift real GDP and inflation numbers last year before falling back into a deflationary trap. Yet the Japanese experience has seemingly convinced ECB President Mario Draghi that similar policies should be implemented across the Eurozone.
Last quarter, the Japanese economy shrank by an annualized 7.1%; business investment fell by 5.1%; and residential spending was down 10%. This is after one of the most massive Keynesian quantitative easing efforts in the history of the world.

So, let’s go to Japan, which may now have to retitle itself “the land of the setting sun,” since it is facing the steepest expected decline in population and in workforce-to-population ratio on the planet.

Land of the Setting Sun

Japan’s long-awaited “recovery” is already losing steam without the effective implementation of Prime Minister Shinzo Abe’s “third arrow” of structural reform, which to my mind was always the most critical element of his entire “Abenomics” project (and of course the most politically difficult). Despite massive fiscal and monetary stimulus and a desperate attempt to boost tax revenues by hiking the sales tax this past April, Japanese GDP collapsed in Q2:



Let’s review how Japan got there.

Prime Minister Abe took office in late December 2012 and, together with his (initially reluctant) colleagues at the Bank of Japan, quickly fired the first two fiscal and monetary policy arrows, which aimed to propel the world’s third-largest economy out of its deflationary trap. The third arrow has yet to fly.

Source: Wall Street Journal, March 2013


Since January 2013 the Bank of Japan has expanded its balance sheet by 78% (42% on an annualized basis)…



… and pushed the USD/JPY exchange rate to a six-year low of a fraction under 109 yen per dollar as of the market close yesterday.



In true Keynesian form, the Japanese government ran a massive fiscal deficit in 2013, equivalent to 8.4% of GDP. This was its 22nd consecutive year of deficit spending, starting in mid-1992…



… despite the fact that the Japanese public-sector debt-to-GDP ratio is quickly approaching 250%:



While inflation has popped to its highest level since the early 1990s…..



… headline CPI has been decelerating since May and could quickly revert to deflation in the event of continued economic weakness, as was the case after the 1997 tax hike… which would then bring on even more “money-financed” deficit spending.

Abe advisor Etsuro Honda was very clear on this point: “Regardless of the next sales tax hike, it could be that additional monetary easing might be called for if inflation and demand fail to pick up and the output gap doesn’t narrow…. I can fully see the possibility that such a situation will occur.”

Of course, the party cannot go on forever. More than twenty years of constant deficit spending and public-sector debt growth have finally led to a situation where debt service and entitlements are crowding out the government’s general budget.



And now the situation is turning dangerous. Japan has been flirting with current account deficits for the past few years, and the trend looks decidedly negative over the coming decade. That, in turn, could force the Abe administration to look for foreign investment to fund its ongoing operations, pushing interest rates up dramatically to the point that debt service and entitlements could consume more than half the annual operating budget.



Bottom line: Abenomics has delivered a bounce in economic growth and inflation, but it’s failing to push Japan into a self-sustaining recovery. Without a detour through structural reforms (which would be quite painful), this road leads to higher public debt balances and even more dysfunction in the medium term, leaving Japan only a shock away from disaster. As predicted here three years ago, I continue to believe that the yen will be over 200 to the dollar by the end of the decade, and possibly much sooner.



Keynesians argue that Abe had the right idea, he just didn’t spend enough and will need to spend a lot more in the near future. In other words, fiscal and monetary stimulus can lift inflation and boost growth in the short term… but the problem is that you can’t have that stimulus if you want to consolidate the national debt and boost tax revenues at the same time.

Some economists would argue that Abe’s policies don’t necessarily have to add to the debt load, as long as the government has a firm commitment from the central bank to monetize the debt along the way. The fact that that would destroy the buying power of the yen doesn’t seem to be a consideration for them. The elderly on fixed incomes might disagree.

So with their highly leveraged banking system and already crushing sovereign debt loads, why wouldn’t the Europeans embrace the same model?

Draghi’s Turn at Abenomics?

I’ve written extensively on the Eurozone in recent months, so I will keep this section brief.

Much of Southern Europe has been mired in depression, with hopelessly slow or negative growth rates, low inflation or outright deflation, and extremely high levels of unemployment (especially among young workers), for several years.

It’s a toxic situation for a multi-country monetary system that still lacks the underpinning of banking or fiscal unions. Demonstrations in the Catalonia region of Spain, inspired by this week’s Scottish referendum, reveal the very real political risks that are only growing with voter frustration.

Perhaps it was just talk, but Mario Draghi laid out a three-point plan similar to Abe’s in his presentation at the recent Jackson Hole meeting of central bankers. It quickly acquired the sobriquet “Draghinomics.”
Draghi recently cut the ECB’s already-negative interest rates and has promised a large round of quantitative easing. But the core problems facing Europe are not interest rates or a lack of liquidity but rather a structurally unwieldly labor market, too many regulations being dreamed up in Brussels, a lack of capital available to small businesses, and major regulatory headwinds for business startups.

Compound all that with the significant structural imbalances between Northern and Southern Europe, dramatically overleveraged banks, and an obvious sovereign debt bubble, and you have all the elements of a major crisis in the making.

That the Eurozone is a fragile and politically unstable union will come as no surprise to Thoughts from the Frontline readers who have been diligently perusing my letters for the past several years, but it is a critical point that we cannot ignore. How, I wonder, can Draghi even hope for a successful European implementation of a three-point plan like Japan’s – where a leader who started with very strong approval ratings has burned through most of his political capital before structural reforms have even gotten off the ground?

Draghi simply does not have the political power to make the changes that are necessary. All he can do is prop up a failing system with liquidity and low rates, which will ultimately create even more serious problems.

The Failure of Monetary Policy

There are many economists, with Paul Krugman at their fore, who believe that Keynesian monetary policy is responsible for the United States doing better than Europe. I beg to differ. The United States is outshining Europe due to the combined fortuitous circumstances of massive new discoveries of unconventional oil and gas, new technologies, and an abundance of risk-taking entrepreneurs. Indeed, take away the oil boom and the technology boom centered in Silicon Valley, and the US would be as sclerotic as Europe is.

None of the above has anything to do with monetary policy. In fact, I would argue that current monetary, fiscal, and regulatory policy is getting in the way of that growth.

Robert A. Hefner III, chairman of The GHK Companies and the author of The Grand Energy Transition: The Rise of Energy Gases, Sustainable Life and Growth, and the Next Great Economic Expansion, wrote a wonderful piece in last month’s Foreign Affairs, entitled “The United States of Gas” (hat tip, Dennis Gartman).

Consider how much can change in one year alone. In 2013, on properties in Oklahoma in which the GHK Companies hold interests covering 150 square miles, one large U.S. independent company drilled and completed over 100 horizontal wells. Had those wells been drilled vertically, they would have exposed only about 1,000 feet of shale, whereas horizontal drilling allowed nearly 100 miles to be exposed. And rather than performing the 100 injections of fracking fluid that a vertical well would have made possible, the company was able to perform between 1,000 and 2,000 of them. The company’s engineers also tinkered with such variables as the type of drill bits used, the weight applied while drilling, the rotation speed of the drill, and the size and number of fracking treatments.

Thanks to that continuous experimentation, plus the savings from scale (for example, ordering tubular steel in bulk), the company managed to slash its costs by 40 percent over 18 months and still boost its productivity. The result: in 2014, six or seven rigs will be able to drill more wells and produce as much oil and gas as 12 rigs were able to the year before. Since the shale boom began, over a decade ago, companies have drilled about 150,000 horizontal wells in the United States, a monumental undertaking that has cost approximately $1 trillion. The rest of the world, however, has drilled only hundreds of horizontal wells. And because each borehole runs horizontally for about one mile (and sometimes even two miles) and is subjected to ten or more fracking injections, companies in the United States have fracked about 150,000 miles of shale about two million times. That adds up to around a thousand times as much shale exposed inside the United States as outside it.

There is a divide in the United States, and indeed in the world, between those who believe (and the emphasis is on believe) that government in all its various shapes and sizes is the font of all growth and progress and those who believe that it is individual effort and free markets that “move the ball down the field” of human progress. Count me in the latter group.

Government is necessary to the extent that we need to maintain a level playing field and proper conduct, but with the recognition that wherever government is involved there are costs for that service that must be paid by the private market and producers. For example, almost everyone thinks that the government’s being involved in student loans is a public good. We should help young people with education, right? Except that John Burns released a report this week that shows that student loans will cost the real estate industry 414,000 home sales. Young people are so indebted they can’t afford to buy new homes. Collateral damage?



The unintended consequences of government policies and manipulation of the markets are legendary. But often unseen.

Monetary policy as it is currently constructed is only marginally helping private markets and producers. Monetary policy as it is currently practiced is an outright war on savers, which sees them as collateral damage in the Keynesian pursuit of increased consumer demand.

It is trickle-down monetary policy. It has inflated the prices of stocks and other income-producing securities and assets, enriching those who already have assets, but it has done practically nothing for Main Street. It has enabled politicians to avoid making the correct decisions to create sustainable growth and a prosperous future for our children, let alone an environment in which the Boomer generation can retire comfortably.

It is a pernicious doctrine that refuses to recognize its own multiple failures because it starts with the presupposition that its theory cannot fail. It starts with the presuppositions that final consumer demand is the end-all and be-all, that increased indebtedness and leverage enabled by lower rates are good things, and that a small room full of wise individuals can successfully direct the movement of an entire economy of 300 million-plus people.

The current economic thought leaders are not unlike the bishops of the Catholic Church of 16th-century Europe. Their world was constructed according to a theory that they held to be patently true. You did not rise to a position of authority unless you accepted the truth of that theory. Therefore Galileo was wrong. They refused to look at the clear evidence that contradicted their theory, because to do so would have undermined their power.

Current monetary and fiscal policy is leading the developed world down a dark alley where we are all going to get mugged. Imbalances are clearly building up in almost every corner of the market, encouraged by a low-interest-rate regime that is explicitly trying to increase the risk-taking in the system. Our Keynesian masters know their policies and theories are correct – we must only give them time to more perfectly practice them. That the results they’re getting are not what they want cannot be their fault, because the theory is correct. Therefore the problem has to lie with the real world, full of imperfect people like you and me.
What our leaders need is a little more humility and a little less theory.

Washington DC, Dallas, Chicago, Athens (Texas), and Boston

I find myself in the Hill Country north of San Antonio, Texas, attending the Casey Research Summit, where I speak tomorrow. I’m surrounded by many friends in very pleasant circumstances. And when I hit the send button, I will have two days of fascinating conversations ahead of me. I am doing a number of videos with various interesting personalities, which we will post on the Mauldin Economics site in the coming weeks. More on that later.

On Monday I fly back to Dallas, where I will stay until the end of the month, then head off to Washington DC. In the middle of October I’ll visit Chicago, Athens (Texas), and Boston, all in one week.

I can't hit the send button without noting that Jack Ma, the Chinese ultra-billionaire founder of Alibaba, was at the New York Stock Exchange for the launch of his IPO and sought out my friend Art Cashin, saying “I can't leave without a picture with Art Cashin.” As one of Art's friends subsequently wrote on our round-robin group email, Jack is clearly a man who understands who is really running things. The incident also shows that anyone can be a groupie. But what really intrigues me is that here is one of the richest men in the world, a force in China, obsessively focused on creating a merchandising machine, and yet he is so in touch with the world of investment and business that he watches CNBC enough to know who Art is. And to appreciate the character and class that Art has shown us for years – and want to meet him. Jeff Bezos may have his work cut out for him in the coming years.

Have a great week and tell a struggling businessman that you appreciate his work.

Your ready for some fun conversations analyst,
John Mauldin



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Monday, September 15, 2014

Thoughts from the Frontline: What’s on Your Radar Screen?

By John Mauldin


Toward the end of every week I begin to ponder what I should write about in the next Thoughts from the Frontline. Much of my week is spent in front of my iPad or computer, consuming as much generally random information as time and the ebb and flow of life will allow. I cannot remember a time in my life after I realized you could read and learn new things that that particular addiction has not been my constant companion.

As I sit down to write each week, I generally turn to the events and themes that most impressed me that week. Reading from a wide variety of sources, I sometimes see patterns that I feel are worthy to call to your attention. I’ve come to see my role in your life as a filter, a connoisseur of ideas and information. I don’t sit down to write with the thought that I need to be particularly brilliant or insightful (which is almighty difficult even for brilliant and insightful people) but that I need to find brilliant and insightful, and hopefully useful, ideas among the hundreds of sources that surface each week. And if I can bring to your attention a pattern, an idea, or thought stream that that helps your investment process, then I’ve done my job.

What’s on Your Radar Screen?

Sometimes I feel like an air traffic controller at “rush hour” at a major international airport. My radar screen is just so full of blinking lights that it is hard to choose what to focus on. We each have our own personal radar screen, focused on things that could make a difference in our lives. The concerns of a real estate investor in California are different from those of a hedge fund trader in London. If you’re an entrepreneur, you’re focused on things that can grow your business; if you are a doctor, you need to keep up with the latest research that will heal your patients; and if you’re a money manager, you need to keep a step ahead of current trends. And while I have a personal radar screen off to the side, my primary, business screen is much larger than most people’s, which is both an advantage and a challenge with its own particular set of problems. (In a physical sense this is also true: I have two 26-inch screens in my office. Which typically stay packed with things I’m paying attention to.)

So let’s look at what’s on my radar screen today.

First up (but probably not the most important in the long term), I would have to say, is Scotland. What has not been widely discussed is that the voting age was changed in Scotland just a few years ago. For this election, anyone in Scotland over 16 years old is eligible. Think about that for a second. Have you ever asked 16-year-olds whether they would like to be more free and independent and gotten a “no” answer? They don’t think with their economic brains, or at least most of them don’t. If we can believe the polls, this is going to be a very close election. The winning margin may be determined by whether the “yes” vote can bring out the young generation (especially young males, who are running 90% yes) in greater numbers than the “no” vote can bring out the older folks. Right now it looks as though it will be all about voter turnout.

(I took some time to look through Scottish TV shows on the issue. Talk about your polarizing dilemma. This is clearly on the front burner for almost everyone in Scotland. That’s actually good, as it gets people involved in the political process.)

The “no” coalition is trying to talk logic about what is essentially an emotional issue for many in Scotland. If we’re talking pure economics, from my outside perch I think the choice to keep the union (as in the United Kingdom) intact is a clear, logical choice. But the “no” coalition is making it sound like Scotland could not make it on its own, that it desperately needs England. Not exactly the best way to appeal to national instincts and pride. There are numerous smaller countries that do quite well on their own. Small is not necessarily bad if you are efficient and well run.

However, Scotland would have to raise taxes in order to keep government services at the same level – or else cut government services, not something many people would want.
There is of course the strategy of reducing the corporate tax to match Ireland’s and then competing with Ireland for businesses that want English-speaking, educated workers at lower cost. If that were the only dynamic, Scotland could do quite well.

But that would mean the European Union would have to allow Scotland to join. How does that work when every member country has to approve? The approval process would probably be contingent upon Scotland’s not lowering its corporate tax rates all that much, especially to Irish levels, so that it couldn’t outcompete the rest of Europe. Maybe a compromise on that issue could be reached, or maybe not. But if Scotland were to join the European Union, it would be subject to European Union laws and Brussels regulators. Not an awfully pleasant prospect.

While I think that Scotland would initially have a difficult time making the transition, the Scots could figure it out. The problem is that Scottish independence also changes the dynamic in England, making it much more likely that England would vote to leave the European Union. Then, how would the banks in Scotland be regulated, and who would back them? Markets don’t like uncertainty.

And even if the “no” vote wins, the precedent for allowing a group of citizens in a country within the European Union to vote on whether they want to remain part of their particular country or leave has been set. The Czech Republic and Slovakia have turned out quite well, all things considered. But the independence pressures building in Italy and Spain are something altogether different.

I read where Nomura Securities has told its clients to get out of British pound-based investments until this is over. “Figures from the investment bank Société Générale showing an apparent flight of investors from the UK came as Japan’s biggest bank, Nomura, urged its clients to cut their financial exposure to the UK and warned of a possible collapse in the pound. It described such an outcome as a ‘cataclysmic shock’.” (Source: The London Independent) The good news is that it will be over next Thursday night. One uncertainty will be eliminated, though a “yes” vote would bring a whole new set of uncertainties, as the negotiations are likely to be quite contentious.

One significant snag is, how can Scottish members of the United Kingdom Parliament continue to vote in Parliament if they are leaving the union?

I admit to feeling conflicted about the whole thing, as in general I feel that people ought have a right of self-determination. In this particular case, I’m not quite certain of the logic for independence, though I can understand the emotion. But giving 16-year-olds the right to vote on this issue? Was that really the best way to go about things? Not my call, of course.

Emerging Markets Are Set Up for a Crisis

We could do a whole letter just on emerging markets. The strengthening dollar is creating a problem for many emerging markets, which have enough problems on their own. My radar screen is full of flashing red lights from various emerging markets. Brazil is getting ready to go through an election; their economy is in recession; and inflation is over 6%. There was a time when we would call that stagflation. Plus they lost the World Cup on their home turf to an efficient, well-oiled machine from Germany. The real (the Brazilian currency) is at risk.

Will their central bank raise rates in spite of economic weakness if the US dollar rally continues? Obviously, the bank won’t take that action before the election, but if it does so later in the year, it could put a damper on not just Brazil but all of South America. Take a look at this chart of Brazilian consumer price inflation vs. GDP:

Mbeki

Turkey is beginning to soften, with the lira down 6% over the last few months. The South African rand is down 6% since May and down 25% since this time last year. I noted some of the problems with South Africa when I was there early this year. The situation has not improved. They have finally reached an agreement with the unions in the platinum mining industry, which cost workers something like $1 billion in unpaid wages, while the industry lost $2 billion. To add insult to injury, it now appears that a Chinese slowdown may put further pressure on commodity-exporting South Africa. And their trade deficit is just getting worse.

Who’s Competing with Whom?

We could also do a whole letter or two on global trade. The Boston Consulting Group has done a comprehensive study on the top 25 export economies. I admit to being a little surprised at a few of the data points. Let’s look at the chart and then a few comments.



First, notice that Mexico is now cheaper than China. That might explain why Mexico is booming, despite the negative impact of the drug wars going on down there. Further, there is now not that much difference in manufacturing costs between China and the US .
Why not bring that manufacturing home – which is what we are seeing? And especially anything plastic-related, because the shale-gas revolution is giving us an abundance of natural gas liquids such as ethane, propane, and butane, which are changing the cost factors for plastic manufacturers. There is a tidal wave of capital investment in new facilities close to natural gas fields or pipelines. This is also changing the dynamic in Asia, as Asian companies switch to cheaper natural gas for their feedstocks.

(What, you don’t get newsfeeds from the plastic industry? Realizing that I actually do makes me consider whether I need a 12-step program. “Hello, my name is John, and I’m an information addict.”)

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.


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