Sunday, August 28, 2011

The Next Twelve Months.

As the days of summer draw to a close, we are filled again with uncertainty about the future. The scares of 2008 have not been erased from the minds of the investors and we are constantly looking over our shoulder to watch out for the double dip recession. But 2011 is not 2008. The central bankers have learned their lesson or so you would think. Perhaps they are better prepared in terms of addressing the crisis, but they still do not understand how to solve the crisis on a permanent basis. Much of the crises of 2011 are actually fiscal crisis and credit crisis. To solve a fiscal crisis with a monetary tool is not only ineffective, but a complete waste.

The threats facing the world economy today are ironically the things which were responsible for the progress for much of last 40 years. The globalization of trade and interdependent nature of the economies. The Keynesian theory of growth followed by the world governments, which depend on debt to deliver prosperity. The desire of the politicians to hang on to power by providing or promising to provide everything to everyone. And of course, the growing power and greed of the “Bankers” to manipulate the political class and engage in excessive speculation.

In the USA, from the period of dot com bust, till date, the political class and their henchmen in the Fed, have created bubble after bubble by borrowing and injecting liquidity in the system. There was no job growth, no real income growth, only an illusion of prosperity, created by simply inflating asset prices. Stock markets went up and up, house prices went higher forever, fooling the mass that they are far wealthier and they need not save or produce anything. Only one country in the western world has bucked this trend. That country is Germany. But there also they were fooled by megalomaniac politicians, notable among them Mr. Helmut Kohl. Helmut Kohl, a post world war 2 politician, who grew up in the guilt of wars, wanted to become a world statesman and thus pushed for the creation of a unified Europe and Euro. While Euro has helped German export machinery to a great extent, it has also tied Germany to other profligate countries in Europe and its periphery that do not have the fiscal or work ethics of Germany.

So in 2011, we are faced with two headwinds not one. The economic powerhouse of the USA is slowly turning to recession again and Sovereign defaults in Europe is a real possibility and banking crisis in those “soon to default” countries is going to explode sooner than expected.

For all the news of BIRC countries who will take us to economic salvation, these countries cannot even save themselves, let alone the world. China and India are just other developing countries, who will soon turn to emergency market from emerging market, when the markets in the USA and Europe dries up and protective barriers start to come up. Make no mistake, politicians will install protectionism to appease their vote bank and the globalization that we know will be a thing of the past. When the unemployment rate hits past 10%, who do you think the politicians will blame for the loss of jobs? They won’t take any blame themselves. They will sure find scapegoats and the easy ones that too.

Anyway, let’s just look at the real GDP figures of USA.

The 1st revision of the 2nd Quarter GDP figure stands at barely 1%. So year on year we are below 1.5% and the 3rd quarter is not going to be pretty either.  Normally, consumers get the feel of economy better and earlier than the sale-side economists in the big banks. So the following chart says.

The GDP and Consumer sentiment have mostly walked together. So what can we expect here? GDP following the sentiment or sentiment climbing up?

And then we have glorious politics. The presidential election of the USA in 2012. With the bitter partisan divide that we have seen so far, the slash and burn method employed by the Republicans, and their pledge to make Obama one term president, we can be sure that they will do anything to turn the voters away from the incumbent president. What better way than to sabotage the economy.  Historically, the 3rd year of the presidential cycle is the best in terms of stock market returns and the 4th year is the worst.  You can read it here;

When we combine all these three, we can be almost certain that a recession is in the cards by 2012. Stocks typically go down 40% or more in a recession, but this one is going to be a depression, not just our garden variety recession. In addition to the negative economic growth in the USA, we are going to have sovereign default in Europe and possibly a banking collapse there as well.(More on that,later)  All these toxic combinations will lead to massive balance sheet contraction and we are looking at an uncharted territory 12 months down the line. In short-term, I think we might still re-test the lows of August or might even go below it, before the Fed is forced to tip its hand with more liquidity. If that happens, it will consistent with the script of 3rd year cycle and also the fact that when January of a 3rd year of a presidential cycle has been positive, 90% of the time, the stock markets in that year have ended in positive territory as well.  

That is another reason, I am not expecting the bottom to fall off yet, but we are not far from the cliff either.

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