2012 Predictions: The Results

Last year I took a chance and threw my own projections into the ring. Similar to Byron Wien and Edward Harrison, I mostly selected events that were widely seen as having a low probability (less than 33%) but which I believed held a greater than 50% chance of occurring. Let’s see how I did...

1) Greece leaves the Euro - As the year progresses the Greek economy continues to contract and unemployment continues to rise, surpassing 50% for youth. This combination of factors offsets attempts to reduce the budget deficit as the country repeatedly misses EU and IMF required targets. Despite potential for further bailouts, the Greek people finally decide the consequences of tied promises outweigh the benefits of remaining in the Euro. Greece defaults on all debts, returning to a heavily depressed drachma.

Result - Wrong (0-1). During 2012, Greece was successful in reducing its budget deficit by 30 percent and staying in the Eurozone. This success was in large part due to further defaults on public debt and another bailout. Unfortunately for the Greek people. the price of these efforts remains extraordinarily high. The economy may have contracted as much as 6.5 percent in 2012, the fifth year of recession, according to forecasts in the 2013 budget. Meanwhile both the general and youth unemployment rates continue to soar, reaching ~27 percent and ~58 percent, respectively. At this point Greece is clearly in the midst of a Depression and showing no signs of recovering anytime soon. Greek tolerance of increasing unemployment and decreasing prosperity remains a surprise, although radical political parties have been gaining support. For now Greece remains in the Eurozone, but a future exit remains likely.

2) Italy and Spain lose access to credit markets - A Greek default raises concerns about the potential for creditors to face actual losses on EU sovereign debt. The ECB’s measured efforts are not strong enough to overcome fear and concern about future growth in Italy and Spain. Deep recessions take hold in both countries, pushing deficits higher.

Result - Wrong (0-2). A Greek default and concerns about the European economy weighed heavily on EU sovereign debt during the first half of the year. By the summer, ten-year bond yields in Spain and Italy were at 7.75 percent and 6.75 percent, respectively, and rising. With the countries at risk of losing access to credit markets, ECB President Mario Draghi came forth with a plan to cap sovereign interest rates using open-ended outright monetary transactions (OMT). Draghi’s threat was enough to generate a 180 degree turn in EU sovereign debt markets, but nowhere near enough to turn around the economies. Italy and Spain both returned to recession this past year, pushing fiscal deficits and unemployment higher. While Italy’s unemployment rate remains closely tied to the EU-wide level of ~11 percent, Spain’s general and youth unemployment rates have quickly caught up to Greece’s levels. Eventually Draghi’s Liquidity Bluff Will Be Called, potentially sooner rather than later as a strengthening euro may reignite the EU crisis.

3) The Eurozone enters recession - Practically the entire Eurozone falls into recession, including the likes of France and Germany. A deteriorating economic outlook causes deficit estimates to be raised across the board, facilitating credit rating downgrades. Agreements for greater austerity fail to stem the tide and other attempts to kick the can down the road are pursued.

Result - Correct (1-2). The euro zone economy contracted 0.2 percent in the second quarter and 0.1 percent in the third, meeting the technical definition of a recession. The fourth quarter drop is looking even worse following recent news that Germany  saw output shrink 0.5 per cent between October and December. Although Germany managed to run a slight fiscal surplus, at the expense of growth, Spain’s budget deficit probably exceeded 9 percent for a fourth year in 2012. The first half of the year did witness credit downgrades and austerity agreements, but Draghi’s big kick at the end of summer pushed any further actions into future years.

4) China’s GDP growth falls below 7% - As exports to Europe contract, the busting of China’s housing bubble continues unabated. Expectations for massive monetary easing in Europe and the US, along with fear of flare ups in the Middle East sets a floor under energy and food commodity prices. Monetary easing and fiscal stimulus in China are applied too slowly to prevent growth from slowing below the supposedly necessary 8%. (Note: This will be not be considered a hard-landing, which I deem growth below 5%. That may come in 2013, but for 2012 most economists/analysts will be able to maintain expectations of a soft-landing.)

Result - Wrong (1-3). During the third quarter China’s growth rate slowed to a three-year low of 7.4 percent, but the year-end tally will probably be around 7.7 percent. As growth slowed and housing prices fell early in the year, the government took action to allow a smoother transition between governments. Fiscal stimulus has pushed growth and inflation higher in the last few months, but at the expense of rebalancing the economy toward consumers for future sustainability.

5) Oil prices will spike above $120, finish year below $90 - (Using WTI crude prices, currently ~$102) At some point during the year Iran attempts to block the Strait of Hormuz. Further attempts to overthrow governments in the Middle East, possibly some that only recently gained power, hit the headlines again. Combined with global monetary easing, oil prices will move higher and gasoline will once again hit $4 per gallon in the US. These higher prices will exaggerate the reduction in global demand for other goods and push growth lower. As fears of a global recession take over, oil prices will fall, finishing the year down more than 10%.

Result - Wrong, but close (1-4). Fears about Iran and the Middle East never really materialized this year but that did not prevent a wild ride in oil prices. After rising to over $113 in April, WTI crude prices dropped all the way down to $80 in August (daily price history). A rally in the last week of the year brought the closing price slightly back above $90. Brent crude prices diverged significantly from WTI in 2012, keeping gas prices at the pump high throughout the summer. Gas prices peaked at $3.94, not quite $4, but nevertheless reached a record-high average of $3.62 per gallon.

6) US enters recession in 2nd half - Despite higher 4th quarter GDP in 2011, the lower savings rate and energy prices are unlikely to add much growth in 2012. With Europe contracting and China slowing down more than expected, US exports will take a hit. Extensions of the payroll tax cut and unemployment benefits will help ensure the federal deficit holds above 8%. Housing prices will continue to fall (based on Case-Shiller) causing the savings rate to once again reach 5%. By the end of 2012, the US will be in a recession (although NBER may not confirm this until 2013).

Result - Wrong (1-5). Despite Europe contracting, China slowing down and the federal deficit dropping to 7% (still over $1 trillion), US GDP growth remained positive throughout 2012. After falling to 1.3 percent in the second quarter, annualized GDP growth jumped to 3.1 percent in the third quarter. Although current estimates for fourth quarter GDP are below 1 percent, the US is most likely not in a recession at this time. Partially behind the positive growth was the impact of housing prices rising over 5 percent and the savings rate remaining below 4 percent.   

7) Federal Reserve extends forecasts for ~0% rates until 2015 - As growth in the US weakens once again and the global economy slows, expected inflation over the next ten years (based on Cleveland Fed estimates) will fall towards 1%. With unemployment holding steady around 9%, the Fed will move it’s forecasts for the first interest rate hike out to 2015. (Some form of QE3 is also likely, but aside from promoting short-term speculation, the effects on growth are likely to be muted.)

Result - Correct (2-5). Expected inflation over the next ten years fell consistently during the course of the year to approximately 1.5 percent (chart below). Although unemployment improved materially, dropping below 8 percent, the Federal Reserve still felt the urge to step up monetary stimulus. On September 13th, 2012, the FOMC extended its projections for maintaining “exceptionally low levels for the federal funds rate...at least through mid-2015” while enacting a plan to purchase “additional agency mortgage-backed securities at a pace of $40 billion per month” indefinitely. Since QEternity was insufficient to boost growth, the Fed also enacted QE4 to raise the rate of balance sheet expansion.


8) President Obama will win re-election - Generally a weakening economy has been poor for incumbents but this time will be seen as abnormal circumstances. The troubles in Europe and high unemployment will actually spark desire for a more interventionist government. Given the choice between Obama and Romney, the President will win re-election by a slim margin (2% or less).

Result - Correct (3-5). President Obama crushed Romney in the 2012 election based on the electoral college, however the popular vote was decided by less than 3 percent.

9) The US dollar rises over 5% - (Based on dollar index) In spite of QE efforts and another sizable deficit, the US dollar retains its safe haven status. As fears of European defaults spread and China’s slowing growth impacts commodity prices, the dollar will continue to trend higher.

Result - Wrong (3-6). As fears spread about European default and a slowdown in China, the dollar rose several percent into the summer months. When those fears were assuaged by politicians, not economic data, the euro began a strong rally. By the end of the year, the dollar had essentially finished flat.

10) Bonds outperform stocks - The consensus once again favors stocks, although US Treasuries have now outperformed stocks over the past 1, 10 and 30 year horizons. With global growth slowing, inflation expectations will fall. Before this bull market in bonds ends, 10- and 30-year Treasuries may reach 1% and 2%, respectively.

Result - Wrong (3-7). Slowing global growth, falling inflation expectations and stagnating corporate earnings were not enough to deter stocks from a very strong performance in 2012. The Bernanke put morphed into a proactive Fed determined to push asset prices higher and succeeding to the tune of over 15 percent. While stocks were riding towards new highs, the bull market in bonds also remained intact. The 10- and 30-year Treasuries hit their respective lows of 1.43 and 2.46 during the summer before heading higher into year end. Ultimately 10- and 30-year Treasuries last year posted returns of only 3 percent and 2.5 percent, respectively.   

That’s the end of it. 3-7 is certainly a bit of a disappointment, especially given the direction of events through the first half of the year. That being said, the logic behind each prediction was sound and far more on target than the end result suggests. My main takeaway is that politicians are far more determined to maintain the status quo than I had expected. The underlying economic (and social) problems have once again been kicked down the road for future governments to handle. As long as that pattern holds, current optimism and modest growth can persist for another couple years.

My hope is to have Predictions for 2013 out by the end of next week. Stay tuned.  

The US Dollar Currency Hegemony Will Persist

In the The Real Reason the US Dollar Can’t Lose, Michael Sankowski (Monetary Realism) comments:

One of the big scares out there is there will be a shift away from the U.S. dollar into the Chinese Yuan, and this shift will drive U.S. interest rates dramatically higher. Here’s the Economist throwing in a rather silly statement:

“The good news for the dollar is that the Chinese yuan is not yet widely accepted and suffers from higher inflation, reducing its usefulness. But a shift in the world’s reserve currency could be swifter than many assume.”

This is simply silly. A multi-trillion real value shift can’t happen quickly. The United States still has a huge proportion of valuable real assets. Foreigners want access to those [assets], and that involves getting U.S. dollars at some point. The value of the dollar is tied to the getting access to U.S. markets.

(Note: changed access to assets for clarity)

There is some good discussion in the comments, but I want to highlight a wonderful paper on this subject by David Fields and Matias Vernengo titled Hegemonic Currencies during the Crisis: The Dollar versus the Euro in a Cartalist Perspective (http://www.levyinstitute.org/publications/?docid=1374). The authors initially offer an introduction to money, comparing the Metallist versus Cartalist approach. Although debate about the historical creation of money continues, currently:

Money derives its properties from the state’s guarantee, and the monetary authority ensures the creditworthiness of the state by keeping its fiscal solvency.6 In its own domestic currency the national state is essentially always creditworthy, and default is impossible, since the central bank can always buy government bonds and monetize the debt. (p. 6)

With concerns of solvency removed from the equation, the authors move on to the fear of unsustainable trade deficits:

There is no balance of payments constraint for the hegemonic country and the principles of functional finance apply on a global basis. (p. 6)

Having alleviated these fears about the fall of the dollar, Fields and Vernengo conclude

It is the power to coerce other countries that is central for monetary hegemony. (p. 7)

While China’s remarkable growth has no doubt increased its ability to coerce other countries, it remains nowhere close to matching the US. Current economic struggles in both China and Europe further reduces the likelihood that any nation (or union) will challenge the US global position in the near future. The US dollar looks set to remain the monetary hegemony for the foreseeable future.

Debt Inequality Remains Major Headwind To Growth

Three months ago I discussed the potential of a forthcoming profit recession, in part, due to a declining govt deficit. Then a few weeks back I noted:

A significantly stronger dollar combined with weakening growth in Europe and China may have brought about a US profit recession even earlier than growth pessimists expected.

Lastly, following revised Q1 data, I showed that a US corporate profit recession had already begun.

Yesterday Charles Hugh Smith offered a great post highlighting many of the same headwinds to corporate profits. The following chart, in particular, caught my attention:
While I often discuss the importance of aggregate levels of debt in the economy, the distribution of that debt also has ramifications for economic growth. Since 2007, fiscal and monetary policy has largely attempted to spur growth by encouraging the private sector to once again embrace debt as a means of consumption and investment. Unfortunately, large government deficits and monetary stimulus have helped raise the income and wealth of the top 5% much more than the bottom 95%. As incomes continue to stagnate for the bottom 95%, interest costs on outstanding debt practically ensure that the above ratio will continue rising unless households actively deleverage.

Since many economists fail to include private debt in their models, policy recommendations continue to ignore the above problem that provides one of the major headwinds to greater  economic growth and wealth equality. Resolving this issue, potentially through credit writedowns or a debt jubilee, should be the focus of policy going forward.

Rising Dollar Ignores Monetary Stimulus

Here’s another fun fallacy quashed! Most mainstream media continues to discuss the Federal Reserve’s easing actions as a means to monetise the debt and/or devalue the US dollar against foreign currencies. This presumption has led many to incorrectly forecast rising or hyper-inflation over the past few years. Well, after two rounds of QE and one round of Operation Twist, the US dollar now resides firmly above its level at the time of the Lehman bankruptcy and the last two attempts at monetary stimulus...
Source: Dollar has gone up since Lehman, QE1, QE2, Op Twist at Mike Norman Economics

Deleveraging by the private sector (and a large current account deficit) continues to negate inflationary pressures stemming from the Fed’s actions and the government deficits. With global growth slowing at an increasing pace, the dollar may still have plenty of room on the upside to run.  

China's "Dollar Shortage" and "Capital Outflow Problem is the Real Ticking Time-Bomb for Markets"

The sad truth that many don’t realise is that these moves to internationalise the currency have less to do with Beijing’s wish to modernise and much more to do with a need to draw dollars into the system to cover the country’s growing “dollar short” position.

But what happens if the strategy fails? What happens if foreigners decide the last thing they want is yuan exposure (due to China economic bubble fears), and would much prefer to keep hold of their US dollars?

What happens if instead of a dollar inflow you get a mass capital outflow from China, with as many Chinese as possible converting yuan-denominated assets into dollars, seeing the yuan fall in value versus the dollar due to what is now an over-valued position?

Recent developments in offshore/onshore markets and forward markets, unfortunately, seem to suggest this is exactly what’s happening.

Read it at FT Alphaville
Why China’s RMB exodus IS the story
By Izabella Kaminska

Hugh Hendry has recently stated that China will be the last shoe to drop. Although reliable data out of China continues to be sparse, signs are pointing in the wrong direction. China has been unable to materially alter the composition of its growth and will face significant challenges in trying to spur domestic consumption going forward. It remains unclear as to whether any country has ever achieved a soft-landing in bringing down inflation and investors don’t appear willing to place strong bets that China becomes the first. Currently markets remain focused on the disintegration of the Eurozone, but problems in China are growing in the background.  

Liberals Demonstrate Conservative Bias for Manufacturing

Last Friday, over at TripleCrisis, Jeff Madrick posted 10 Questions for Economists Who Oppose Manufacturing Subsidies. Conversations regarding this topic have been persistent for much of President Obama’s term in office and are unlikely to dwindle heading towards the election. Although the questions are posed towards mainstream economists, of which I am not, here are some succinct, sensible, non-mainstream responses in opposition to to manufacturing subsidies.  

1. Doesn’t America already have an anti-manufacturing strategy? It has enthusiastically supported a high value for the dollar since the 1990s. The high dollar raises export prices but, as noted, very much helps Wall Street attract capital flows and lend at low rates. Shouldn’t we get the value of the dollar down?

Answer - Lowering the value of the dollar will make exports cheaper, but it will likewise make imports more expensive. Many Americans, not on Wall Street, will therefore be able to purchase less goods with the same income. Reducing the dollar value is also an imprecise mechanism that could very well drive up food and energy prices well in excess of any benefits to manufactures.

2. Don’t Germany, China, and many other countries subsidize their own manufacturing industries? Do you really think the World Trade Organization works all these out? If they do subsidize, isn’t it only fair to place manufacturing on a level playing field and subsidize our own?

Answer - While Germany, China and many other countries do subsidize their own manufacturing industries, America currently does as well. A cursory glance at the tax statements of GE, GM, Ford and a host of other manufacturers will display a multitude of tax breaks/loopholes specifically to support American manufacturing. A better questions is whether or not American taxpayer dollars are best used supporting/bailing out manufacturing companies so that foreign consumers can buy goods at cheaper prices.

3. Doesn’t manufacturing having a multiplier effect? Some say we can never boost the share of manufacturing adequately. So what if we create even as much as another 2 or 3 million manufacturing jobs. (The president is settling for a couple of hundred thousand.) But wouldn’t manufacturing’s multiplier effect stimulate the rise of other manufacturing and service industries and the creation of other jobs?

Answer - Despite receiving massive subsidies over the past decade(s), the companies mentioned in question 2 have been shedding American workers. Efforts to stimulate manufacturing jobs are more likely to redirect funds from other sectors, resulting in American job losses outside of manufacturing. Accounting for the potential production of those 2 or 3 million outside of manufacturing, any multiplier effect is not necessarily positive. A cardinal rule of economics is there is no free lunch, hence creating manufacturing jobs will not be free.

4. How can we get our trade deficit down if we don’t sell more manufactures? They account for about seven-eighths of our exports. I know the answer some of you will give: savings. But do you really think raising our savings rate will reduce capital inflows adequately to lower the dollar in order to promote more exports?

Answer - This question assumes that reducing the trade deficit is definitively positive and that a lower dollar is needed to promote exports, both of which are not true. Until this past year, Japan ran persistent trade surpluses notwithstanding an almost perpetually rising Yen. Regardless, a different answer than the one expected: services. As noted above, manufactures are not the only form of exports (or imports). During the past century, US exports shifted dramatically from agriculture to manufactures. Over the next century is may shift again towards services.

5. Without manufacturing, what will we export? Isn’t there a point at which we lose too many industries and labor skills to make a comeback? Given the symbiotic nature of business clusters and supply chains, aren’t we rapidly losing the subsidiary companies that make manufacturing and exports possible?

Answer - As mentioned above, similar arguments were made when manufacturing began encroaching on agriculture’s territory. Looking back, few people probably wish that agriculture had been protected so that many of us would still be working on farms today. Google makes enormous profits across the globe even though it manufactures almost nothing. What’s wrong with most Americans eventually working in offices rather than factories?

6. Weren’t persistent trade imbalances a major cause of the 2007-2008 financial crisis as debt levels soared? Don’t you worry that the export-led models of China, Germany, and Japan are unsustainable? On a worldwide basis, they are really debt-led growth models. How do we get balance without promoting our exports?

Answer - Trade imbalances and debt levels are separate, relatively uncorrelated factors, of which the latter was more likely a major cause of the financial crisis. Total debt levels soared in the US and many European countries with import-led models as well. If debt levels are a major problem, which I believe is true, than one option to achieve balance would be reducing subsidies to acquiring debt, such as the mortgage interest deduction.

7. Isn’t manufacturing a source of innovation in and of itself? Isn’t that where the scientists and engineers are? Don’t we learn and innovate by doing? One commentator recently said that those innovations are exploited by others, so it doesn’t matter. Really? Then maybe we should stop promoting R&D altogether.

Answer - Manufacturing is one source of innovation, but what about companies like Amazon, Netflix, Apple and Facebook. Is buying goods online today not cheaper and quicker? Is watching movies and listening to music not more accessible for less cost? Can we not interact with people all over the world far quicker and more easily? These companies and others are constantly innovating and improving our lives, undeterred by a lack of manufacturing or scientists..

8. Where will the good jobs come from? You always say high technology. But America now imports more high-technology products than it exports, especially to China. Even Germany has a high-technology deficit with China. I ask again, where will the jobs come from as technology gets more complex? Do you think more education is really an adequate answer, the only answer?

Answer - Why are manufacturing jobs so ‘good’? Does this imply that all non-manufacturing (or high-tech) jobs are ‘bad’? What about teachers or doctors? The future offers a potentially massive increase in service jobs with new markets that have not yet been conceived. Education within schools may not be adequate and is certainly not the only answer, however education through increasing work apprenticeships may be a good place to start.

9. Why did the job market do so poorly throughout the 2000s? If you say we can’t know where jobs will come from, that the market will decide, then why aren’t you worried about the job market’s poor performance over the last decade, with huge losses in manufacturing jobs? Again, you say, inadequate education. Yetaccording to CEPR’s John Schmitt, we have not produced more good jobs as GDP grew — good jobs measured by wages and benefits provided. Is there hard evidence we don’t have the labor to fill the high-technology jobs — and if we did, are there enough jobs going unfilled to make a difference?

Answer - According to CEPR’s Dean Baker, in The End of Loser Liberalism: Making Markets Progressive, supposedly “free-trade” agreements have exposed many lower wage (manufacturing) jobs to foreign competition while erecting barriers against trade in higher wage areas such as health care and law. At the same time, patent laws and tax codes have been continually adjusted to protect large corporations and enforce monopolies. The economy is also structured to encourage home buying/building, which for some time vastly expanded construction jobs beyond a sustainable amount. Even with all of these poor choices, about 92% of Americans desiring work are employed today. Americans have the knowledge and expertise to reach full-employment, but policies that raise the cost of hiring workers and discourage small business creation are not helping.

10. Will the jobs come from services? The rapid growth of finance has fouled up the numbers. Finance services did provide high-paying jobs, but we now know many of these were phantoms. And the salad days may be over. The other big area of productivity growth in services was retail. We all know what kinds of jobs Wal-Mart provided.

Answer - Yes, services will provide one source of new jobs but hopefully finance will not be a significant contributor. It remains unclear why manufacturing jobs are necessarily better than retail or other service jobs. Either way, the beauty of capitalism is that the future is unknown but there has been no better economic system in history for supporting growth. Jobs will return, but manufacturing subsidies are not the best approach and may well cause more job losses than they create.

Predictions for 2012

With countless others offering predictions for the year ahead, I thought I’d take a chance and throw my own projections into the ring. Similar to Byron Wien and Edward Harrison, I mostly selected events that are widely seen as having a low probability (less than 33%) but which I believe hold a greater than 50% chance of occurring.

1) Greece leaves the Euro - As the year progresses the Greek economy continues to contract and unemployment continues to rise, surpassing 50% for youth. This combination of factors offsets attempts to reduce the budget deficit as the country repeatedly misses EU and IMF required targets. Despite potential for further bailouts, the Greek people finally decide the consequences of tied promises outweigh the benefits of remaining in the Euro. Greece defaults on all debts, returning to a heavily depressed drachma.

2) Italy and Spain lose access to credit markets - A Greek default raises concerns about the potential for creditors to face actual losses on EU sovereign debt. The ECB’s measured efforts are not strong enough to overcome fear and concern about future growth in Italy and Spain. Deep recessions take hold in both countries, pushing deficits higher.

3) The Eurozone enters recession - Practically the entire Eurozone falls into recession, including the likes of France and Germany. A deteriorating economic outlook causes deficit estimates to be raised across the board, facilitating credit rating downgrades. Agreements for greater austerity fail to stem the tide and other attempts to kick the can down the road are pursued.

4) China’s GDP growth falls below 7% - As exports to Europe contract, the busting of China’s housing bubble continues unabated. Expectations for massive monetary easing in Europe and the US, along with fear of flare ups in the Middle East sets a floor under energy and food commodity prices. Monetary easing and fiscal stimulus in China are applied too slowly to prevent growth from slowing below the supposedly necessary 8%. (Note: This will be not be considered a hard-landing, which I deem growth below 5%. That may come in 2013, but for 2012 most economists/analysts will be able to maintain expectations of a soft-landing.)

5) Oil prices will spike above $120, finish year below $90 - (Using WTI crude prices, currently ~$102) At some point during the year Iran attempts to block the Strait of Hormuz. Further attempts to overthrown governments in the Middle East, possibly some that only recently gained power, hit the headlines again. Combined with global monetary easing, oil prices will move higher and gasoline will once again hit $4 per gallon in the US. These higher prices will exaggerate the reduction in global demand for other goods and push growth lower. As fears of a global recession take over, oil prices will fall, finishing the year down more than 10%.

6) US enters recession in 2nd half - Despite higher 4th quarter GDP in 2011, the lower savings rate and energy prices are unlikely to add much growth in 2012. With Europe contracting and China slowing down more than expected, US exports will take a hit. Extensions of the payroll tax cut and unemployment benefits will help ensure the federal deficit holds above 8%. Housing prices will continue to fall (based on Case-Shiller) causing the savings rate to once again reach 5%. By the end of 2012, the US will be in a recession (although NBER may not confirm this until 2013).

7) Federal Reserve extends forecasts for ~0% rates until 2015 - As growth in the US weakens once again and the global economy slows, expected inflation over the next ten years (based on Cleveland Fed estimates) will fall towards 1%. With unemployment holding steady around 9%, the Fed will move it’s forecasts for the first interest rate hike out to 2015. (Some form of QE3 is also likely, but aside from promoting short-term speculation, the effects on growth are likely to be muted.)

8) President Obama will win re-election - Generally a weakening economy has been poor for incumbents but this time will be seen as abnormal circumstances. The troubles in Europe and high unemployment will actually spark desire for a more interventionist government. Given the choice between Obama and Romney, the President will win re-election by a slim margin (2% or less).

9) The US dollar rises over 5% - (Based on dollar index) In spite of QE efforts and another sizable deficit, the US dollar retains its safe haven status. As fears of European defaults spread and China’s slowing growth impacts commodity prices, the dollar will continue to trend higher.

10) Bonds outperform stocks - The consensus once again favors stocks, although US Treasuries have now outperformed stocks over the past 1, 10 and 30 year horizons. With global growth slowing, inflation expectations will fall. Before this bull market in bonds ends, 10- and 30-year Treasuries may reach 1% and 2%, respectively.

For some potential investment themes based on these predictions, I suggest taking a look at Gary Shilling’s 2012 Investment Themes.  

A September to Remember

Three years ago, on September 7th, 2008, the federal government nationalized Fannie Mae and Freddie Mac. The following week, Bank of America bought a Merrill Lynch, Lehman Brothers filed for bankruptcy and AIG was bailed out by the Federal Reserve. During the next couple weeks, Washington Mutual also went belly-up, Wachovia was acquired and the remaining investment banks converted into bank holding companies. In markets, credit spreads widened drastically and equity market volatility heightened substantially, including the S&P 500’s largest loss in history of over 100 points (nearly 9%).  

This year, following a weak August, credit and equity markets have gotten off to a miserable start in September. During the first two days of trading, the S&P lost nearly 4% and at the moment is down close to 3% in the futures market. Losses in Europe are even more staggering, with several major indices already losing nearly 10% this month, following grater than 15% drops last month. Sovereign and bank credit markets, especially in Europe, are also freezing up as the crisis worsens. These are ominous early signs of another September to rival its historic predecessor.

Although only three short years have passed, the global economy appears to be following a similar pattern. After trying to kick the can down the road for more than year, numerous underlying problems are unraveling around the world in concert with one another. Each successive attempt at papering over issues has a shorter shelf-life and the time for politicians to get ahead of the troubles is rapidly decreasing. A quick tour around the world’s major economies will shed light on the ensuing global crisis.

US-

Reminiscent of headlines in 2008, Friday witnessed new troubles stemming from apparently plagued mortgage-backed securities. From the FHFA website (http://www.fhfa.gov/webfiles/22599/PLSLitigation_final_090211.pdf):

Washington, DC -- The Federal Housing Finance Agency (FHFA), as conservator for Fannie Mae and Freddie Mac (the Enterprises), today filed lawsuits against 17 financial institutions, certain of their officers and various unaffiliated lead underwriters.  The suits allege violations of federal securities laws and common law in the sale of residential private-label mortgage-backed securities (PLS) to the Enterprises.  

Complaints have been filed against the following lead defendants, in alphabetical 

order:

1. Ally Financial Inc. f/k/a GMAC, LLC

2. Bank of America Corporation

3. Barclays Bank PLC

4. Citigroup, Inc.

5. Countrywide Financial Corporation

6. Credit Suisse Holdings (USA), Inc.

7. Deutsche Bank AG

8. First Horizon National Corporation

9. General Electric Company

10. Goldman Sachs & Co.

11. HSBC North America Holdings, Inc.  

12. JPMorgan Chase & Co.

13. Merrill Lynch & Co. / First Franklin Financial Corp.  

14. Morgan Stanley

15. Nomura Holding America Inc.

16. The Royal Bank of Scotland Group PLC

17. Société Générale  

These complaints were filed in federal or state court in New York or the federal court in Connecticut.  The complaints seek damages and civil penalties under the Securities Act of 1933, similar in content to the complaint FHFA filed against UBS Americas, Inc. on July 27, 2011.  In addition, each complaint seeks compensatory damages for negligent misrepresentation.  Certain complaints also allege state securities law violations or common law fraud.

Although the full repercussions cannot be known at this time, the fall out may prove very large. While the Obama Administration has been working hard to undermine an investigation by New York’s AG into similar matters, another part of the administration has seemingly subverted those goals. This lawsuit almost certainly dampens the Administration’s hope that the largest banks could avoid serious litigation in return for a small fee ($8.5 billion). Of the institutions listed above, several pose interesting related questions, yet the biggest questions are tied to Bank of America’s solvency.

Witnessing its stock fall more than 50% this year (shown below), Bank of America has continually denied claims about needing to raise capital. Despite these apparently false claims, the bank raised capital by selling warrants and preferred stock, along with a significant stake in the China Construction Bank, at steep discounts. Even with these actions, confidence remains fragile, as shares tumbled again on Friday.

Due to its purchases of Countrywide and Merrill Lynch, Bank of America was effectively sued in three separate claims noted above. Combining these claims generates total claims against in excess of $50 billion. However, these claims only represent a small portion of potential liabilities outstanding related to the sale of MBS and foreclosure fraud. Whether the bank ultimately settles these claims or attempts to fight in court, losses will almost certainly be significant and uncertainty regarding the outcome will weigh on the firm for some time.

Apart from unknown losses discussed above, the bank is also currently sitting on untold losses related to its own mortgage holdings, as well as European bank and sovereign debt. Thanks to the ongoing suspension of mark-to-market accounting, the actual market value of current assets is highly unpredictable. Regardless, markets are suggesting current assets should be marked down by billions of dollars and those numbers can only increase as markets weaken.

How long will the confidence last? With Bear Stearns, Merrill Lynch and Lehman Brothers, the final straw seemed to be when institutional investors began pulling funds in mass. Considering recent votes in the US House, another TARP seems unlikely at this juncture. If Friday’s lawsuits spur another significant sell off in the bank’s stock, institutional investors may decide to seek safety elsewhere. Were a run on Bank of America to occur, it’s hard to envision several other weak banks not being targeted as well. The Dodd

Europe -

On a timeline basis, the sovereign debt crisis in Europe feels most similar to the US housing crisis. Nearly 18 months ago, problems began showing up in EU periphery countries, notably Greece. As yields widened, the country’s solvency was questioned and after ECB intervention, a bailout was concocted. Despite a couple more bailouts, Greece’s economy continues to deteriorate under the weight of austerity and a strong Euro. Over the past few days, short-term yields have exploded upwards, with the 2 year exceeding 50% (shown below). Not only are markets pricing in 100% chance of default, but far more significant losses than the most recent proposals by the EU/ECB. Apparently recognizing Greece represents a solvency issue, not liquidity problem, the IMF and several EU nations are reconsidering any further aid. 

After Greece, Portugal and Ireland also fell victim to economic deterioration and questions regarding their own solvency. These countries have been locked out of credit markets for more than a year now. Having also received bailouts for austerity measures, economic performance has not turned around and debt levels have worsened. Resolutions involving some form of default still appear almost certain.

While most market participants expected Spain to become the next casualty of bond vigilantes, markets surprisingly leap frogged Spain, instead attacking Italy. Starting in July, 10 year yields quickly spiked from under 5% to early 6.5% (shown below). Fearful of the consequences, the ECB once again stepped in to purchase Italian and Spanish debt to stem the rising yields. After successfully pushing yields back below 5%, the markets have once again responded, sending Italian yields back above 5.5% today. 

The recent rise comes after Italy’s government attempted to roll back various austerity measures. As Kiron Sarkar notes in a post on The Big Picture (http://www.ritholtz.com/blog/2011/09/people-who-play-with-fire/):

“The Italians better reconsider their recent attempts to backslide from their commitments – they have a large debt maturity this week – some E14.6bn and E62bn by the end of September (the highest ever in a single month). In total, Italy must roll over E170bn by end December – Whoops.”  

Trying to sell that amount of debt may generate a further sell off in Italian debt, for which the ECB and EU appear unprepared.

Sovereign debt problems are on the verge of spiraling out of control, which is especially scary considering the lack of political unity in Europe. Time is running out on a grand solution and if politicians are forced into a reactive resolution, markets and economies will likely pay the price. As sovereign debt continues to be repriced lower, the resulting market losses are weighing heavily on European banks.

Stock prices of European banks have been falling precipitously over the past couple months. After a brief reprieve due to several countries banning short-selling on the securities, prices are once again falling. As I detailed in Europe Revives Failed Policies of 2008, these measures have been proven to fail and may even worsen the situation. Currently, credit spreads for interbank lending are showing significant strain and approaching levels last witnessed during the crisis of 2008 (shown below, top). Credit default swaps (CDS) on many banks are also reaching new records, potentially stemming from banks trying to hedge counter party risk (shown below, bottom).

Given the global nature of banking, credit problems in Europe may leak into US markets.  Once again, the ECB and Fed (primarily) will be forced to provide liquidity to the financial system. Similarly to the US, if one major bank faces a run, several others are likely to follow. With most of Europe already either in recession or experiencing sub-1% growth, the entire EU risks falling into another recession by year end. Risks are now increasing at a rapid pace, hence the next few weeks promise to be very interesting.

Asia -

After suffering a horrendous earthquake and tsunami, the Japanese economy fell back into recession. While trying to rebuild, global economic fear has sent cash flocking to the safe-haven Yen. Recently hitting all-time highs against the dollar (shown below), a strong Yen has caused exports to falter and hindered the economic recovery. Attempts by the BOJ to intervene in exchange markets have proved woefully unsuccessful. Further hurting the potential for recovery has been an unwillingness to increase deficit spending, which could generate internal demand and weaken the currency. 

As for China, the country has been fighting inflation by raising reserve requirements. History shows that this measure is not particularly successful in reigning in inflation. Recent moves to let the Yuan float higher are more encouraging. China also faces trouble relating to a fixed investment rate near 50%, potential housing bubble and rapidly increasing bad bank debt. Regardless of specific measures taken to thwart these issues, history suggests the most likely outcome is a “hard landing,” which could represent GDP growth below 5%.

For both of these export driven countries, weakening demand from US and Europe will pose significant problems on top of those already established. As the financial crises of 2008 displayed, global economies are very intertwined in today’s world and the troubles of one large nation will exert pressure upon the others. With equity markets in both these counties having already joined Europe in bear market territory, the immediate future is not looking promising (shown below: Hang Seng, Nikkei, Shanghai).

Over the past two years, markets have responded positively to a stimulus led economic recovery across developed nations. Weakening within credit markets has been largely written off as excessive caution. As credit markets weaken further and economic recoveries falter, it appears this time is not different. Equities have been moving quickly to catch up with credit markets on the way down, however the remaining spread still seems quite wide. Unfortunately the global financial system is practically no more transparent than several years ago, which means questions of solvency, plaguing the market, will be hard to defend against. Measures taken in 2008 to provide liquidity and capital will also be significantly harder to pass in a world concerned with sovereign debt and monetary devaluation.

US and German 10 year yields have now joined Japan in the sub-2% club (shown below), which suggests a lengthy period of minimal economic growth and inflation. As equity markets price in a similar outcome, I expect much further declines. A focus on individual companies with strong balance sheets and high dividends should offer great relative value. As for the dollar, equity weakness, global risk and ultimately an interest rate cut by the ECB will likely provide strength. There are times to seek a return on capital and times to seek the return of capital, I believe now is the latter.

Only three years ago, the global economy witnessed the worst recession since the Great Depression. Few people imagined so short a time could pass before the world was once again faced with such enormous challenges. Back then, September marked the period where issues started to really unravel. Could September once again witness the unfolding of historical events? Only time will tell, but based on the first few days, it certainly appears this will be another September to remember.