Minyanville's Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. The Great Deflation
Japan experienced more than a decade of deflation, and now finally appears to be re-emerging. Could something similar happen here? In a word, No. But something far worse could.
- I've been reading former NY Fed economist and chief economist of Nomura Research Institute Richard Koo's book, "Balance Sheet Recession."
- The book outlines Koo's view of the Japanese deflationary spiral, something he believes was a highly unusual economic aberration called a "balance sheet recession."
- Here in Minyanville deflation is referred to as a decrease in time preferences and risk aversion.
- So, why did Japan suffer from such a lengthy deflation and is the same in store for the U.S.?
- Koo argues that Japan underwent a massive shift in corporate behavior and that this behavior, beyond any structural problems, was the root cause of the country's descent into deflation and the non-performing loan problems.
- For our purposes the distinction between structural finance problems that led to Japan's deflation versus a corporate shift in behavior is irrelevant. Instead this is what struck me as so alarming:
- When we ("we" meaning the handful of Minyanville professors who write about deflation from time-to-time) talk about deflation in the U.S. we are typically talking about a secular shift in consumer behavior (and, by extension corporate behavior) that turns net spenders into net savers (a decrease in time preferences) and forces (by necessity given high levels of consumer debt) a cutback and outright decline in consumption.
- It hasn't happened yet. The consumer continues to spend, though even the Fed's Janet Yellen is worried about what she calls an "unsustainable negative personal savings rate."
- This is what I found so alarming in reading Koo's book: Were you aware that Japan, long known as a country of savers, saw virtually UNCHANGED consumption levels between 1990 and the present? Consumption remained flat.
- Koo explains: "This means the frequently heard argument that the economy is faltering because consumers' worries about the future are driving savings and depressing consumption is not supported by the data."
- Now, think about that for a moment. Japan, with a high savings rate and a cushion, saw virtually unchanged consumption levels throughout the entire course of that country's bout with deflation.
- No wonder the Fed is so worried about "anchoring inflation expectations," and by extension, no wonder we should be so worried about the new housing deflation.
2. Stealth Depression
We'll get to the expected update on housing deflation in a moment, but first let's consider a crazy question. Are we already in a limited (for now) Stealth Depression?
- Suppose a person with an income of $1,000 normally spends $900 and saves $100. The $900 becomes someone else's income and the $100 will be loaned out by the bank to be spent somewhere else.
- As Koo explains in his book, Balance Sheet Recession, during a balance sheet recession the person with $1,000 income still spends $900 and saves $100. The $900 enters the economy as someone else's income, as usual, but the $100 finds no borrowers as companies pay down debt.
- As financial institutions find no takers for the money to be lent interest rates fall to make the money cheaper. As we have seen, they can fall to zero, even negative in real terms.
- The other consequence is that the economy sees demand of only $900 generated as that $900 spent is someone else's income. If that person saves 10%, then that (10% of 900 is 90) reduces the economy further, to $810, and so on.
- As Japan saw, that cycle slowed the economy, reduced asset prices even further, and forced companies to work even harder to pay down debts.
- Here is where it gets interesting. Suppose that due to such an economic slowdown the first person's income is reduced from $1,000 to $500? At this level, the person may be unable to save at all because of rent, mortgage, outstanding debts. Suppose the second person who receives that $500 is forced into the same situation, unable to save to meet obligations.
- This is how the vicious balance sheet recession cycle concludes. A new economic situation emerges as both households and corporations are so impoverished they can no longer save any money.
- Hmmm, considered in the light of our negative personal savings rate, this sounds somewhat familiar. Corporate balance sheets here still show lots of cash, but consumers seem to be trapped in the $500 world outlined above.
- Do you know what Koo calls this $500 world? "And it is this ¥500 world that is typically called the "Great Depression."
- Hey, we're halfway there.
3. WSJ Avoids the "D-Word" in Housing Article
The Wall Street Journal this morning notes what we first brought up on the Buzz and Banter last week: the build in inventory of unsold homes is pressuring prices. Though they managed to avoid using the "d-word."
- A continued rise in inventories of unsold homes in August is likely to put more downward pressure on home prices in parts of the U.S., the Wall Street Journal reported this morning.
- Inventories of homes in 18 large metropolitan areas across the country expanded by 4.7% in August from a month earlier, according to data compiled by ZipRealty Inc., a real-estate brokerage firm based in Emeryville, Calif., the article noted.
- While the article didn't mention deflation specifically, it referred to the mindset of deflation euphemistically, if unwittingly. "Many potential buyers are waiting for prices to come down further."
- That, in a nutshell, is the psychology of deflation.
- Take a look at a recent story from Maryland: “The financial incentives that homebuilders are dangling before suddenly reluctant buyers may get even more enticing as the slumping home sales market crawls to 2007," Gazette.net reported.
- "[A] price guarantee program, offered by Mid-Atlantic Builders Inc. of Rockville, is probably the first incentive of its kind in the state. When a buyer signs a new home contract, Mid-Atlantic guarantees the buyer gets a break should prices of similar homes dip before the closing. The program eases the concerns of gun-shy buyers, said John Lavery, the company’s vice president and director of sales and marketing. ‘‘We found that the concern among buyers was that there might be a better deal later,” Lavery said."
- That is deflation. Period. So while the Fed talks about "anchoring inflation expectations," the deflationary psychology is already here... in force.
- Ask yourself this question: What goods are you worried about purchasing right now, as soon as possible before prices rise? Milk, eggs, paper towels? Gas? Are there any goods you want to buy as soon as possible to avoid the loss of purchasing power? Inflation is most problematic when it pushes consumption forward to avoid the loss of purchasing power down the road.
- Because consumption has peaked, however, it is not being pushed forward. That is why upward pricing pressure is itself sowing the seeds for deflation. Deflation does the opposite. It pushes consumption back as people wait for lower prices. And that is what the Fed fears most.
4. Inflation... for now. Inversion... for later?
European Central Bank council member Nicholas Garganas told Bloomberg news the ECB is ``very worried'' about inflation.
- European bonds continued their recent decline and two-year yields hit their highest level since August 2002, after European Central Bank council member Nicholas Garganas said the bank is ``very worried'' about inflation, Bloomberg reported.
- Garganas said the ECB's benchmark interest rate, at 3 percent, is still too low.
- He is now the fourth ECB member in the past week to suggest the ECB will continue hiking rates into 2007.
- "There is still a considerable amount or degree of monetary accommodation which needs to be withdrawn,'' Garganas said in an interview with Bloomberg yesterday in Basel, Switzerland.
- The ECB has increased its benchmark rate four times since December.
- Meanwhile, the spread in yields between two-year and 10-year German bonds narrowed to 13 basis points yesterday, from 90 basis points a year ago.
- The spread is now the smallest since December 2000, flattening the yield curve.
- There is increasing speculation the yield curve will probably invert, just as 2s and 10s have inverted in the U.S.
- Welcome to the club, Europe. Given consumer debt levels of your own, perhpaps you too are sowing the seeds for deflation.
5. I'm With Stupid
Yesterday I heard on television that anyone who thinks commodities are going to lead stocks lower is stupid. Well, I guess I'm with stupid. So is Australia. And much of the Asia-Pacific region.
- Australian stocks have now been down for five straight sessions.
- Asian stocks have dropped to a five-week low with the Nikkei 225 down another .48% overnight.
- Meanwhile, crude oil prices are riding a six-day losing streak.
- See the chart below showing the CRB Index collapse (sorry, don't know what else to call if when the index is down more than 11% in 22 trading days and nearly 7% in the past nine trading days) with crude overlaid.
- The CRB Index is now well below the long-term, multi-year trendline with crude threatening to follow-suit.
- But look, the CRB Index decline is just energy-based, right? Crude is down 17% from its all time high. Gold is below $600 for the first time in two-and-a-half months.
- Actually, the CRB Index decline is more broad-based than one would think.
- Five of the six CRB sub-sectors were in the red yesterday (shown below in continuous index points, not percent). Only Livestock/Meats eked out a gain:
- Industrials (-10.2)
- Grains (-1.7)
- Livestock./Meats .27
- Energy (-15.0)
- Precious Metals (-29.1)
- Softs (-7.5)
- The key question is whether the secular commodities story remains intact.
- Is this a severe correction in a secular uptrend, or the end of the secular bull?
No positions in stocks mentioned.
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