*Date: *December 22, 2004 11:49:57 AM PST
*Subject: The Daily Reckoning - Canary in a Coalmine
* The Daily Reckoning
Wednesday, December 22, 2004
The Daily Reckoning PRESENTS: What can we learn from the housing
situation in England? Well, according to John Mauldin, we seem to be
playing follow-the-leader with them when it comes to the housing
market...just six months behind...
CANARY IN A COALMINE
by John Mauldin
In 1996, the New York Federal Reserve did a study on what indicators
were the most reliable predictors of a recession. The only one of six
indicators that was significantly reliable was an inverted yield curve.
They later did a private study with over 20 factors and still the only
dependable indicator was the inverted yield curve. I read the studies in
1999.
In a normal world, short-term rates are lower than long-term rates. This
makes sense, as investors want to be compensated for the risk of the
longer holding period. There are exceptions to this rule, and at times
short-term rates rise above long term rates, giving rise to what is
known as an inverted yield curve. Typically, when the yield curve is
inverted or negative for 90 days, you get a recession in about 12
months. Actually, it is more than typical. In the United States, every
time we have had a period of negative yield curves, we have had a
recession within a year.
Thus, in August of 2000, as the yield curve in the United States went
negative, I predicted the United States would enter a recession in the
summer of 2001, and since the stock market loses an average of 43% in a
recession, it followed that the stock market would tank. Quite the out
of consensus call at the time. Although the NASDAQ was still in a swan
dive, the New York Stock Exchange was climbing to within shouting
distance of its previous high. The economy seemed to be moving along
quite nicely. But the yield curve was staring us right in the face.
Now, I was not the only one that had read the Fed report. I am almost
sure that every one of the Blue Chip economists had read it as well. But
none predicted a recession. Things just looked too good, and none of the
other data suggested a recession in the works. You can bet Greenspan had
read the paper, but he waited until January to start cutting rates.
I remember calling the author of the paper at the Fed and asking him
whether he thought that we would be in recession within a year. "It will
be interesting to see," he said.
While today the U.S. yield curve is slowly flattening, it is nowhere
near an inverted yield curve and not signaling a recession. But I have
spotted an inverted yield curve in the world, across the pond, in
England. And it worries me, as I wonder if it is a pre-cursor to
problems in the United States. Let's survey the current situation in
England.
U.K. unemployment is an amazing 2.7%. I am sure there are examples, but
I cannot recall a major economic country with such a low unemployment
rate. Inflation, although rising, is still under 2%. Wages rose by 4.4%
in the three months through October, the highest rise in several years
and more evidence of nascent inflation.
The housing market is doing quite well, thank you. In what everyone
calls a bubble, housing in England still rose 12.5% year over year in
November, although only 0.2% in the last month. Could it be slowing?
U.K. household debt is 140%, which is above U.S. levels.
The Bank of England recently noted, "Any sustained fall in [house]
prices would reduce homeowners' cushion of housing equity. This might
reduce their opportunity to re-mortgage to consolidate other debts or to
lower their monthly payments. Financing difficulties would be
exacerbated if any fall in house prices were accompanied by a wider
economic slowdown."
And government spending is on the rise. Quoting the team from Gavekal,
"Just like the United States, the United Kingdom participated in the
supply-side revolution of the 1980s and 1990s. But unlike the U.S., the
U.K.'s supply-side revolution is in danger of being rolled back. U.K.
government expenditures relative to GDP have been on the rise for seven
long years, and the government has accounted for virtually all
employment growth since 2001. Little by little, increased regulation and
ever-rising public spending are weakening the spirit of enterprise
created by the Thatcher revolution. This is a worrying development and
if left unchecked, will undoubtedly have very negative effects on the
growth prospects of the U.K. economy, and on their equity market."
The Bank of England is in a hard spot. They have been steadily raising
rates to keep inflation in check and to rein in the white-hot housing
bubble. Since the housing market is still doing well, and inflation is
rising, one would think they should continue to raise rates. But with an
inverted yield curve and a very strong pound, raising rates might not be
wise, as that could push the country into recession.
If I lived in England, I would be getting my personal house in order. No
long only stock funds, switching to bonds and absolute return type
investments and funds. While the Fed study on yield curves was based on
U.S. precedent, the rule generally applies everywhere. Thus, precaution
is the order of the day.
But at the beginning of this essay, I hinted about the English situation
perhaps shedding some light on the United States. Let's see if we can
make a case.
Hmmm. A strong housing market that might be peaking. A central bank that
has been raising rates. A solid economy with inflation starting to pick
up. A stock market that looks like it may have peaked? Oh, and did I
mention a very large trade deficit? Sound familiar, my fellow countrymen
and women?
The only thing we don't have is an inverted yield curve...yet. However,
England did not have one as recently as six months ago, and was not all
that out of bounds a year ago. I think England may be six to nine months
ahead of us in the softening process.
England may very well be a canary in the coalmine. While not totally
analogous, there are enough similarities that it gives pause. And bears
watching.
Yes, I know many will point to the positive economic data on both sides
of the ocean. But that misses the main point. The data stays positive,
as will the mainstream economists, up until they turn negative. The
upshot of the Fed study was that only the yield curve showed any
reliability in its predictive ability. Everything else was "noise."
In the late 90's and up until 2002, the vast majority of pundits told us
why "this time it's different. Trade deficits no longer matter. Now they
are all blaming the trade deficit for the declining dollar. But if that
is the case, why is the British pound and Aussie dollar rising?
The world of currency valuations and trade deficits is a very
complicated matter. Yes, trade deficits of the type that the United
States is currently experiencing, as well as that of England and
Australia, are unsustainable. But normally, when one uses the word
unsustainable, one does not think in terms of multiple years, but that
is precisely what can happen. It is entirely likely, even probable, that
the U.S. trade deficit will get worse this next year (barring a drop to
$20 oil).
A dropping dollar is not going to magically fix the deficit as it did in
the 80's. For one thing, the U.S. manufacturing sector is a smaller
percentage of the total economy than it was 20 or even five years ago.
So even if we see exports grow a significant percentage, it is growth
off a smaller base. It will take many years of outsized export growth to
catch up with our growing imports. Unless, of course, we see a recession
and imports actually drop.
That means for the trade deficit to come back into balance imports must
go flat or drop. That is not a happy prospect. Going to Marshall's
[Auerbach of Prudent Bear] latest piece, as he is commenting upon
articles by the IMF and other English institutions that worry about the
housing bubbles in the US, England, and Australia.
"The humbling reality is that across three decades, only one economic
event has been guaranteed to produce balanced trade in the
English-speaking nations: a recession. When the economy is contracting,
people naturally buy less of everything, including imports. Needless to
say, no one appears ready to embrace this option, which means that the
endgame will be much worse - even for those who have sought to conduct
their monetary affairs in a responsible manner, such as the Bank of
England. The current global financial fragility is unlikely to be saved
by mere dollar devaluation; it is solved when the respecting offending
nations restraining their respective profligate tendencies and implement
policies designed to restore national savings to their historic norms.
Of course, if all the offending nations do this together without any
countervailing stimulus from Euroland or Asia, we will see a massive
global contraction.
"The Bank of England and IMF may see this checkmate position coming.
They may be concerned they will see a global income depression on their
watch if housing bubbles burst. They may accordingly be warning global
monetary authorities 1) not let the housing bubbles run any further, but
perhaps more importantly, 2) not pop these bubbles in anything other
than a careful, deliberate, and incremental fashion. That would be nice,
but history shows us that there is a reason why we rarely see bubbles
popping gently."
Today, things are all right. The canary is singing away. But the great
imbalances in world trade will be brought into balance at some point,
even if "unsustainable" is a few years off. It helps to get some early
warning signs. Let's watch that canary closely.
Regards,
John Mauldin
for The Daily Reckoning
Editor's Note: John Mauldin is the creative force behind the Millennium
Wave investment theory and author of the weekly economic e-mail Thoughts
from the Frontline. As well as being a frequent contributor to The Daily
Reckoning, Mr. Mauldin is the author of Bull's Eye Investing (John Wiley
& Sons), which is currently on The New York Times business best-seller
list.
