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  • From: "TradingPostPaul" <tradingpost@riseup.net>
  • To: livingontheland@lists.ibiblio.org
  • Subject: [Livingontheland] looking at which markets - debt, equity, commodities or real estate - were most overvalued
  • Date: Wed, 19 Dec 2007 04:38:32 -0700


I'm seeing dozens of articles from overseas media about this, with varying
predictions for better or worse. I feel obligated to at least pass on
something about it.

paul tradingpost@lobo.net
------------------------------------------

"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."


Where’s the juiciest bear food?
By Martin Hutchinson
http://www.atimes.com/atimes/Global_Economy/IL19Dj02.html

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 US Federal Reserve 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 US$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 would tank and the housing finance market would 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 number one 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
cheerleader, 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.

Gold dust
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, continental western 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 five to six years time China will once again be
enjoying its rapid climb up the league tables of relative and absolute
economic prosperity.

India wobble
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 technology 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 the
country's 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.

Martin Hutchinson is the author of Great Conservatives (Academica Press,
2005) - details can be found at www.greatconservatives.com.








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