Tuesday, January 27, 2009 4 comments ++[ CLICK TO COMMENT ]++

Macro Outlook I

"The only function of economic forecasting is to make astrology look respectable."
-- John Kenneth Galbraith

Making forecasts is never good for one's reputation; but given how my reputation is close to zero or possibly negative, I probably don't lose much by making them ;) This will be my main outlook for the year and the future in general. There will be another post where I will lay out my investment plan for the year (since I am macro-oriented, my investments are mainly driven by my macro view, except for risk arbitrage, distress investing, and such.)

To tell you the truth, regardless of how bad you are at it, I think forecasts are actually a good thought exercise if you are macro-inclined. If, however, you are bottom-up then avoiding forecasts is a good idea (in this case, forecasts, which are nothing more than guesses, will adversely cloud your view.) Before I started my blog, I used to write yearly forecasts on some of the forums I was posting on. My forecasts have a poor track record but interestingly, quite a number of key ones have come true. Unfortunately, it took much longer than I thought and hence I didn't profit much from them (sometimes lost some money too.)

Thoughts On The Past

A few of the big calls that took far longer than I thought but still came true to a large degree were my bearish view of commodities, my bullish view of US$ and bullish view of US government bonds. I had also been bearish on emerging markets, especially the high flyers such as China and India, and it seems to have been a good move to avoid them (although if you were really early, you probably made more money that I would in my whole lifetime!) If anything, I get the feeling that I am too early and hence need to extend my time frame. So, moving forward, I am going to extend my calls. Instead of trying to come up with yearly events, it's better to think of them as long-term multi-year events.

An important thing to keep in mind is that macro forecasts are not simply an attempt to make money. Rather, they are also an attempt to avoid losing money.

Note that I may change my mind on anything I say, as new information becomes available. I am unsure of certain key themes, such as the commodities bubble, and may change my mind on them. The important thing is to develop your world view while absorbing market data. If the situation on the ground changes, you should change your view as well.

There are two parts to this post. In this post I will outline my macro views. In a subsequent post, I will cover my investment plan, including specific investments that are worth following or investing in. Except for some quick points, I am not justifying my macro views since it takes way too long.

I should also note that I will mostly talk about USA but view the rest of the world as being somewhat similar, in a crude sense of course. I follow the view that says all asset markets are closely related and definitely do not buy the de-coupling theory. For instance, many investors don't realize that the European stock markets collapsed before the American one in the 1920's. The inter-linkage between economies back then is far less than now yet asset prices were influenced by the US. Interest rates also move with each other, even though each country has its own economy and government policies. Presently, the linkage is even stronger given the greater amount of international trade.

If you are macro-oriented, your goal is to either invest ahead of everyone or avoid potential problems. That's the whole point of injecting macro into investment plans.

Weak Economic Growth

My view is that the world will be in a slump for 5+ years. I don't expect to see a worldwide depression or anything severe, but I do see low growth for many years. Developed countries will likely see below-potential (3% is roughly the potential of USA) growth while developing countries will likely fluctuate wildly based on political problems arising from weak economic growth. Jeremy Grantham forecasts growth of 2% for the G7 and that is how I'm looking at it as well.

My feeling is that we will see low inflation along with periods of mild deflation (some countries may see high inflation due to political actions.) [note: irrational political actions, such as tariffs, trade embargoes, etc, can alter this so watch for that.] The difficulty will be figuring out if any bouts of collapsing prices is good deflation (declining prices due to productivity/technology/etc) or the bad kind (decline due to slump in demand or wealth destruction.) Right now it's deflation of the bad kind but it'll become difficult to distinguish in the future. In particular, I think it is going to be difficult, if China shows deflationary results, to tell if China is seeing bad deflation or good deflation.

Given how the core problem in the developed world is debt, the paradox of thrift ensures that we won't get a quick recovery. Everyone needs to save but doing so at the same time is bad for the economy.

Weak Asset Prices

I think the world economy will do ok but asset prices will struggle. My guess is that the current period for investors will resemble the late 1930's to 1940's (without the war--hopefully.) Treasury bond yields were very low in the 40's (around 2% for 10 year bonds if I recall) and corporate profits actually kept increasing throughout this period. Yet stock prices didn't really go up much (although if you bought a low such as in 1932 or 1942, you saw gains of 50% or so.)

There are a couple of reasons why I don't see the start of a bull market in stocks right now. Firstly, according to John Napier (I'm planning to buy his book soon,) the worst bear markets--he looked at the 4 big ones--last around 14 years. The current one can be shorter but if you are conservative, assuming that the bear market started in 2000, you have to assume that there may be another 6 years left.

Secondly, regardless of how long a bear market lasts, nearly all of them overshoot on the downside. The reason seems to be psychological, partly arising from massive losses suffered by prior investors. Stocks right now are attractive but not extremely cheap (as in 1982 or 1974 or 1932 or 1942.) So it is more than likely that valuations will decline further (this is almost a certainty if bond yields rise significantly due to a crisis.) However, do keep in mind that this may mean that prices stay flat while earnings catch up.

It is likely that the market will fluctuate in a wide range so traders and stockpickers will probably do really well.

It is important to remember that, for all practical purposes, the bottom in the bear market may be set long before before the "start" of a bull market. That is, technical investors consider the start of a bull market from the point of the absolute bottom. But, in practice, an investor may suffer for a long period after the bottom is in. The classic example is the 70's. The absolute bottom was set in 1974 but unless you picked off that bottom exactly, it was an inflationary nightmware for most investors for the next 8 years. For all intensive purposes, the start of the bull market was in 1982, even though the bottom was back in 1974. Similarly, depending on the index you are looking at, the bottom was set in 1932 but it really wasn't a bull market until the late 40's. The implication of this thinking is that, even if you think the bottom was set in October 2008 (it may not be,) we may still face a rough period for many years.

Collapse Of Mercantilism

We are probably witnessing the beginning of the end of mercantilism. I think the US$-peg by many in Asia or Middle East will break within 5 years. China will gradually move away from the peg while some others alter their pegs more quickly (actually, we have already seen quite a few switch to a peg based on a basket of currencies and we will see more of this.) The problem for the pegged countries is that they may see big inflation problems if growth picks up slightly while USA pursues deflationary policies.

One should also be prepared for adverse trade disputes, capping off with a big trade war. I hope it never comes to this but it won't be a shock. The potentially big conflicts are:

  1. China vs USA: This is a huge problem. China is artificially maintaining a low currency by pegging their currency to the US$ (in a free market, the Renmembi would rise as China prospers and capital flows into the country.) China does this in order to develop its manufacturing-oriented economy. Exporters in USA are disadvantaged by this, although importers benefit. However, the resulting current account deficit in the US is unsustainable and many American nationalists do not look favourably upon this relationship. The Obama administration will be more protectionist, like most left-leaning parties of the world, and will likely take a really tough line than the Bush administration ever did. Obama campaigned on it, although it wasn't high on the list, and we saw Tim Geithner, the new Treasury Secretary, send a signal to China recently by publicly calling out China on its mercantilist policies. I don't think anything serious will happen unless China de-values its currency. Yes, contrary to market consensus expecting the Renmembi to rise, China may actually de-value it if it faces economic problems and wants to boost manufacturing further. Investors should pay keep an eye out on this situation.
  2. Potential problems in Europe: I think there is a moderate risk of serious trade disputes and policy disagreements developing in Europe. We already have some countries like Spain expecting 16% unemployment and seeking lax monetary and fiscal policy, while others such as Germany pushing for a stricter policy. The collapse in the pound and potentially further weakening, which helps British competitiveness, may also ruffle some feathers in mainland Europe (would you rather take a vacation to France or a 30%-cheaper Britain?.)
  3. East Asia vs China: A low risk right now but if East Asian countries, most of them built on an export-oriented economy, devalue their currencies, I suspect China is not going to take it too kindly. There could be some disagreements if East Asian countries become more competitive than some Chinese regions.
  4. OPEC oil price control: This is a very low probability event, at least in my eyes. If we face high inflation--I'm not expecting high inflation so that's why I say it's low probability--it is possible that some oil-importing countries may retaliate against OPEC for its price control of oil.

So those are some events to think about, especially if you are a global investor. Imagine if you overload on emerging market stocks and some dispute arises.

Deflation Over Inflation

A huge call over the next few years is the inflation vs deflation decision. I thought this was a big issue in the last few years but I was wrong. This is an even bigger issue right now. Getting the direction wrong is going to result in a disaster of epic proportions.

Right now, my feeling is that the market consensus is for inflation, with some expecting high inflation down the road. The consensus seems to be that the market hit a bottom late last year and we may start the beginning of the bull market later this year. This thinking seems to come from the consensus economic view of stronger economic growth in the last part of this year. We even have some investors betting heavily on commodities expecting re-flation later in the year.

I am in the mild-deflation/disinflation camp. I think we will see bouts of deflation similar to how it was in Japan (but the situation will be much better than Japan.) It's too long to go into the reasons but to put it bluntly, I don't see how the $30 trillion or so losses in the world, most of which is still not recognized by banks and investors (i.e. fraudsters and ponzi schemes; and investment assets not need to be marked to market) can be "made up" anytime soon. Furthermore, are we really going to see investors jump back into equities and debt in the same manner? How many investors would be willing to contribute to equity capital of banks? How many would provide debt financing to corporations, not to mention private equity? How many citizens would be willing to pump a ton of money into stocks after seeing almost 50% vanishing within an year, while their homes, generally their biggest asset, also plunges 25%?

There is a high chance of USA following the path of Japan (but won't be as bad since USA is more capitalistic and has more diversified economy.) In Japan cash and bonds ruled, as they always do in deflation, and it's quite probable for bonds to outperform stocks for a few years.

Having said all that, one should consider where they might be wrong. I will consider the possibility of high inflation if central banks start monetizing assets in far greater amount than the amount destroyed. So far no sign of that. There is the thinking that the government will come and save the economy, a proposition I believe has been wrong all throughout time. Governments can cushion the blow but they can't reverse the losses. They won't create $30 trillion in wealth and make stock prices, bond prices, house prices, etc, go back to what they were in 2007.

One can also come up with a low probability high deflation case. We may see a sizeable threat of deflation if China implodes and starts dumping goods on the world markets. So, if you are making the high inflation case, then there is also a high deflation case. Both are remote in my eyes.

China Is The Main Story

China will be the most important macro story over the next few years. On the positive side, if the world economy recovers, it will partly be due to China. If China can increase its consumption then it can contribute to future growth, while America and others remain in a mild slump. On the negative, there is a possibility that China may implode. If China enters the situation USA faced in the 1930's, it may face a severe political crisis. This will be a disaster for everyone.

Bullish On US$; Bearish On Gold

I don't have strong conviction but my current view is to remain bullish on US$, a position I have maintained for several years--an incorrect call during that period. Unless the world recovers strongly, and quickly, US$ will see capital favour it. If I am wrong on the US$ call, I will pay a heavy price, as most Canadians who have invested in US stocks in the last decade know all too well.

It's not a strong view but I'm developing a bearish feeling for gold. It's likely too early but I don't see gold doing too well if we enter a long period of low growth and mild deflation... If we face the high inflation situation that some are expecting, we obviously will see gold skyrocket. But that's not my expectation.

Commodities Bull Market Likely Over

Too early to say but it is possible that the commodities bull market is over. The fact that prices are off so much--we are not just talking 20% or 30% but, more like 50% to 70%--seems to imply the end of one of the major bubbles in the last decade. However, different commodities have differing characteristics so it's possible for some of them to do well in 4 or 5 years. For instance, perhaps the bull market in oil and base metals is over but not in soft commodities.

Also, even if the bull market has ended, it does not mean that you won't see rallies of as much as 50%. Some may have hit bottom and rally. The difference, of course, is that you won't have the bull market in your favour as was the cast in the last 10 years. If you mistime things or pick wrong commodity, you will have difficulties.

Avoid Current Account Surplus Countries

This is totally contrarian and counterintuitive to some degree but countries that ran current account deficits will likely perform better than the surplus countries. This is one reason I am far more bullish on USA than many. I think it is possible that countries such as India may also perform better. I'm still bearish on India but less bearish than an year or two ago. A sizeable chunk of the current account deficit of such countries was due to high commodity prices, particularly oil, and if commodities enter a bear market, the deficit should shrink (we are seeing this in the US already.) I am also concerned that the present situation resembles the trade relationships in the 1920's and 1930's. Back then, current account surplus countries, such as USA, suffered far more than current account deficit countries, which was the case with most European countries.

Stock Market May Not Lead The Economy

I was listening to an interview by Russell Napier, the author of the Anatomy of a Bear, a book I'm planning to read, and he said that the stock market does not always lead the economy. It certainly didn't happen in some of the four key bear markets he looked at. I think the same thing is possible now. Given how almost everyone believes the market leads the economy, and hence are quick to jump into the markets in order to avoid missing the train, the contrarian in me says that this time will be more like the severe bear markets of the past than the mini-bears of the last two decades.

(If you do think the economy is going to recover, Napier says that autos and copper are two good indicators.)


4 Response to Macro Outlook I

January 29, 2009 at 1:05 AM


I really enjoy your comments. In particular I'm happy you mentioned Napier. I read his book over the Hoidays- I have a feeling that if your interested in macro forecasts you will love the book.

Quick question where did you hear a Napier interview. I'm interested in hearing his thoughts?

If you can email me at miguel@simoleonsense.com or post a comment on blog.

Keep up the great work. I love reading your work & I try to link to your blog nightly.

Best Regards,
Miguel Barbosa

January 29, 2009 at 10:06 AM

Thanks Miguel. I'll try to hunt for his interview. I ran across an audio interview from last year (or maybe it was late last year) if I remember but I'm not sure how timely it is. That's why I decided not to post it. I also re-listened to one of book interviews from a few years back. The ironic thing is that, although his book came out several years ago, it is probably the perfect book for the present. I'll definitely try to read his book. If I can't buy it, I'll try the library.

February 18, 2009 at 10:18 AM

Hi Sivaram,

first of all, thanks and congratulations for your blog. It is very well written and full of interesting thoughts.

I have a question concerning your bullishness on the US dollar. How much of it is based on some contrarian thought, and how much stems from some form of fundament analysis? I specifically was wondering if you had some target exchange rate for USD/EUR or USD/JPY, say, and then apply some form of margin of safety.

February 18, 2009 at 3:51 PM


I don't have any fundamental analysis supporting my views of the US$. Calling currencies is very difficult--George Soros is good at it though--and I don't think I would be comfortable with betting on them. I don't think you can value it fundamentally and come up with a margin of safety (unless you are an expert on currencies or something.)

My view is based on my belief that we may be in a period of mild deflation. Cash is king during deflation and the US$ is likely to be strong. The fact that its major competitors like the Euro are weakening also helps the US$ (Europe will be worse than America for the next few years.)

I just try to come up with a stance and factor that into my investment considerations. Since I am bullish on US$, I lean more towards owning American stocks. If I turn bearish on US$, I might tilt more towards foreign stocks or American companeis with high foreign exports. So my currency view is just a rough guide. I personally don't have any confidence in it to make a pure currency bet (as others such as Jim Rogers are doing.)

Sorry I don't have a good answer for your interest in currencies but I'm not really into them. I just want to invest in stocks or bonds with some consideration of currencies but that's about it. Trying to determine a margin of safety or some target level seems too tough...

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