In the spirit of the endless year-end speculations about developments in 2008, I thought it worth looking at which markets – debt, equity, commodities or real estate — were most overvalued in December 2007 and hence could be expected to provide the best “bear food” for the year ahead. After all, for us bears picking losers is much more enjoyable than picking winners!
Overall, 2008 looks to be a good year for bears. The Fed has been walking a tightrope since August between the precipices of a collapsing financial system and resurgent inflation. With a 3.2% November Producer Price Index rise (7.2% over the previous year) announced on Thursday and a 0.8% Consumer Price Index rise (4.3% over the previous year) announced on Friday, it can now be officially confirmed that the tightrope has vanished into thin air. The United States over the next 12 months will experience both a collapse in its financial sector and a violent resurgence in inflation, and there’s nothing whatever the Fed can do about it, no interest rate trajectory that will not worsen one problem more than it alleviates the other.
If the Fed lowers interest rates further to bail out Wall Street, it will worsen inflation. Oil prices moved from $70 to $90 on the 0.75% drop in the Federal Funds rate from 5.25% to 4.50% so will surely soar to around $120 if the Fed is foolish enough to lower it to 3%, as several Wall Street and permabull commentators are calling for. Equally, if the Fed were to raise rates, even gently, in order to contain resurgent inflation, the US stock market will tank and the housing finance market will suffer yet further losses, as housing “affordability” diminishes as interest rates rise. The right stance would be a significantly higher level of rates, perhaps in the 6.5%-7% range, which would be fairly close to neutral on inflation, but that would devastate stocks and housing – both necessary declines, but the Fed’s #1 objective is not to be blamed for such events. Most likely, the Fed will be frozen into immobility, keeping interest rates at or near their current levels, in which case both inflation and the housing crisis will steadily worsen, while stocks decline.
The US stock market, after more than a decade of excessive and unjustified optimism, seems destined to crash several thousand points onto the rocks below. The only question is the timing. Should the Bureau of Economic Analysis massage the next few months’ inflation numbers successfully, and the Fed continues to lower interest rates, it is possible that the housing decline will slow, fed as it will be by an ocean of liquidity, so that at least in the first half of 2008 optimism will once again reign. However it seems unlikely that any false dawn of this type will last long; the collapse of the securitization mechanism, and the withdrawal of confidence from asset backed commercial paper vehicles, make it unlikely that the credit bubble can be sustained for much longer – bank balance sheets are simply not large enough to absorb all the necessary paper.
At this point, the election comes into play. The Democrat candidate will undoubtedly be relatively protectionist, so the Republican will be forced to move towards protectionism in order to deflect Democrat attacks on a highly flawed Bush administration economic record. Consequently whoever wins in November 2008 will have made pledges on trade that he or she will find it difficult to ignore. Not only is the Doha round dead therefore, but without the United States somewhere close to acting as free trade cheerleaders, the world seems likely to move into an era of beggar-my-neighbor protectionism similar to the early 1930s although one hopes less intense than that unhappy period. Globalization will go into reverse. The brunt of the cost will be borne, not by India and China, whose economies will remain highly competitive, but by Western consumers, who will find their jobs disappearing as output declines and their living standards suffering as persistent inflation is no longer alleviated by an endless flow of ever-cheaper manufacturing and services from emerging markets.
Outside the United States, it seems likely that the commodities boom or bubble will continue, at least for the first few months of the year. The merits of oil, gold and other commodities as inflation hedges will increasingly recommend them to the huge money pools of hedge funds and sovereign wealth funds. Gold in particular is likely to see quite a spurt — maybe heading towards the $1,500 level. Later in the year, the commodity boom will collapse, but over the year as a whole it seems unlikely that commodity prices will greatly decline.
Given the Fed’s dilemma, long term bonds must be about the most dangerous of current investments (low quality bonds being even more dangerous than Treasuries, as liquidity tightens further.) Rising inflation will weaken their appeal as a safe haven (even index-linked Treasuries will suffer as investors begin to suspect that published inflation figures are massaged) while the tightening liquidity and increasing US budget deficit in a period of US slowdown will tend to drive yields higher. The Fed will be able to do nothing about this; if it reduces short term rates, inflation will drive up long term rates, while if it increases short term rates to combat inflation the entire yield curve will move higher as rate expectations alter.
Housing and other real estate assets may see a modest bounce in value, or at least a slower decline, in the early part of the year as the Fed and other central banks continue trying to stimulate the world economy, producing mostly inflation. The various bailout schemes proposed by politicians will also increase confidence somewhat. Eventually however, as the market comes to realize that the US housing finance market as we have known it for 30 years is dead, the house price decline will continue and indeed intensify.
Outside the United States, the continental West European economies seem likely to have a quiet, albeit somewhat negative year. They do not have real estate bubbles in the process of bursting; indeed German house prices are lower than they were 10 years ago. German mortgage banks would be thus in fine shape – if they had not foolishly speculated in the more “developed” market of US mortgages.
Eastern Europe is a different matter. Too many of these economies have been borrowing internationally to finance their domestic real estate and consumption booms. While the overall trend for these economies to catch up with Western Europe seems likely to continue, balance of payments deficits in the likes of Estonia and Latvia of more than 10% of GDP are likely to prove extremely difficult to finance as international cross-border investment declines into a recession. With liquidity high in the early months of 2008, their recession may be delayed into 2009, but recession there will be.
The one exception to the moderate optimism for Western Europe is Britain, which seems likely to have a very tough year indeed. The financial services business must inevitably suffer a very poor year, and these days that business forms a very high percentage of the London economy, if not of the British economy as a whole. Further, London house prices are overvalued by at least 200% at the high end of the market, and have not yet begun to drop. Unlike in the United States, where the first half of 2008 may see a temporary let-up in the house price decline, in London house prices will drop increasingly swiftly, with the total top to bottom drop of as much as 40-50% over the next few years.
Since most middle class Britons foolishly have their wealth largely tied up in housing, this will have a very severe negative wealth effect on consumer spending. Add in the fact that the profligate Blair/Brown government has increased public spending by more than 5% of GDP during its decade in office, producing a public sector deficit of more than 3% of GDP at the very top of an unsustainable boom, and you have the recipe for the worst downturn in Britain since 1980-82. This time, however the pain will be concentrated not in the manufacturing North of England but in overpriced service-oriented London, and on the successful over-leveraged yuppies who have rendered that city uninhabitable for those of middle incomes. About the only saving grace for the British economy will be a collapse in the value of the pound against the euro as it resumes its long term purchasing power parity of $1.50 against the dollar.
In Asia the principal loser will be China, which is already suffering from tighter credit conditions in the domestic market. Rapid Chinese growth has finally sparked off consumption, while inflation is rising fairly rapidly and real interest rates in the domestic economy remain heavily negative. At some point, Chinese domestic savings in the banking system will prove insufficient to finance both consumption and the continuing needs of loss-making state owned entities. China can solve its domestic banks’ bad debt problems by using its foreign exchange reserves – indeed it is already doing so — but that is bound to lead to further inflation, possibly tending towards hyperinflation. It seems likely that China will in 2008 enter something like the US Great Depression, albeit with high inflation rather than deflation, with an eventual drop in GDP of 20% or so and in the Chinese stock market of 75-90%. That will be extremely painful for Chinese domestic investors, and for those foreign investors who have been sucked into this highly speculative market, but like everything in China it is likely to take place quickly, so that in 5-6 years time China will once again be enjoying its rapid climb up the league tables of relative and absolute economic prosperity.
India is more difficult to read. On the negative side, Indian public spending is increasing far too rapidly, tending to crowd out more productive sectors of the economy, while rising inflation and a bubbly stock market both suggest a downturn is near. Further, the Indian political situation is unstable, with a leftist government led by an aging moderate facing elections in 2009. That seems almost certain to lead to a further bout of wasteful public spending. On the positive side, the Indian economic sectors that have liberated themselves from the dead hand of the “permit Raj” are not going away anytime soon, and seem likely to continue taking market share from their overstuffed Western competitors. On balance therefore, I would see a wobbling beginning to an Indian downturn, with inflation reaching double digits and the government resorting to dubious price control schemes to control its reported level. Further developments will await the election due in spring 2009, about which it is still too early to prognosticate.
The most positive economic picture will be in those countries of East Asia that have remained rather unfashionable since the Japanese bubble burst in 1990 and the East Asian economies crashed in 1997. Japan itself seems likely to continue its steady if unspectacular growth, with the growth rate accelerating if fiscal policy remains tight for 2008, the current government remains in power and interest rates are increased from their current 0.5% to a more normal level of around 2-2.5% (Japan being such a savings culture, moderately higher interest rates tend to stimulate rather than depress the economy.) Taiwan too should do well – as an economy it is extremely liquid and, unlike in 2000, the tech sector is not the focus of the currently impending downturn. However the most likely stock market winner in 2008 is South Korea, currently selling on a price-earnings ratio of only 12. Presidential elections this week and congressional elections in April will probably remove the fairly anti-business government that has hampered Korean growth since 2003 and replace it with the vibrantly pro-business Grand National Party.
So there you have it. Best bear opportunities: London real estate, long-term US bonds and Chinese stocks. Best bull opportunity (not that we bears care much about that): South Korea. Overall, a satisfactorily bearish year, darkening further in its second half.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)