Is the Age of Deleveraging upon us?
November 20, 2010
Gary Shilling is one of the grand wise old men of the finance and investment world, whose track-record in calling major market turns over the past 40 years, is second to none. He has written a new book, The Age of Deleveraging: Investment Strategies for a decade of slow growth and deflation which is a must read for serious students of markets and investing. Dr. Shilling has made some great calls over the years: the 1969 – 70 recession, the early 1970s inventory bubble and the 1973 – 75 recession, the disinflation and long term bond bull market starting in the early 80s (when he forecast that the long bond, then yielding 15.25%, will eventually reach a 3% yield), the bursting of Japan’s 1980s bubble and the dot com bubble of 2000 and finally the recent collapses of the US housing and financial bubble! The key to successful investing over the long-term is to get the major market cycles right – everything else in the interim is just noise, and a distraction. The well known newsletter writer John Maudlin has written a good summary of the book and I have present below the highlights:
- After four decades of leveraging up by the financial and household sectors, deleveraging is underway which is likely to take a decade or more?
- While government borrowing has increased dramatically over the last 3 years (+7.7%), private borrowing over the same period has fallen by more than twice as much (-18.6%).
- Deleveraging is not straight-line process – it occurs in a series of seemingly isolated events, with interim periods of stability ushering in a feeling that all is well, until the next crisis hits.
- This has been the pattern followed in recent years – with (i) the “contained” subprime crisis leading to (ii) initially an implosion of the Bear Stearns hedge funds in June 2008 and then the financial collapse of September 2008, followed by (iii) the collapse of consumer buying in the fall of 2008 and (iv) the coincident global recession, and after a period of calm and euphoria following the $862 billion fiscal stimulus, (v) the eurozone crisis of late 2009 and early 2010.
- Further potential crises lie ahead: another sovereign debt crisis in Europe with Ireland being the focus, a further 20% drop in US house prices due to the excess inventories and foreclosure delays which could push the number of underwater homeowners from 23% to 40% of mortgagors causing a sharp fall in consumer spending , a crisis in US commercial real estate which could exceed the housing crisis, a hard landing in China and a slow-motion train in Japan due to lower demand for its exports and an ageing population.
- GDP growth is likely to average only 2% annually over the coming decade due to: (i) US consumers shifting from a 25 year borrowing-and-spending binge to saving, (ii) financial deleveraging reversing the trend of financing global growth, (iii) increased government regulation stifling innovation and efficiency, (iv) low commodity prices limiting spending by exporting nations, (v) fiscal restraint in developed countries, (vi) rising protectionism hampering global trade, (vii) further weakness in the housing market, (viii) deflation curtailing spending as buyers expect lower prices, (ix) state and local governments to contract.
- Deflation comes in two forms - the good variety which results from excess supply and productivity improvements, and the bad variety which is induced by weakness in demand. We are likely to experience both forms.
- Deflation rates of 2 – 3% annually are expected, which after a few years are likely to result in a rise in deflationary expectations causing consumers to postpone purchases and further slower economic growth.
- There are numerous investment themes which will do well in such a deleveraging environment: avoid consumer discretionary purchase industries, credit card and consumer lenders as consumers tighten their belts and pay down debt; buy US Treasury bonds with 10-year yields declining to 2% and the 30-year to 3% due to slower growth, deflation and their safe-haven status; stocks with high and reliable dividend yields; small cost effective homes and rental apartment sectors; and conventional energy suppliers in North America like coal, nuclear, natural gas, oil sands and related industries (and avoid government subsidy – dependent renewal energy sectors like ethanol, wind, solar and geothermal).
I have been following Dr. Shilling’s views for a few years now, and subscribe to his deeply insightful monthly newsletters as well. The scenario he paints in his new book is consistent with the theme I had referred to in last week’s newsletter – a cold spell in the developed world for most of this decade. Having said that, it does not mean that there will not be 50% plus rallies in stock markets driven by numerous quantitative easing (and fiscal stimulus) programs, eventually followed by precipitous falls just when everybody starts believing the good times are back! The key to success in this environment is to have a disciplined approach, be nimble, focus on the fundamental trends and not be swayed by euphoric (or pessimistic) market gyrations and, finally, take profits early. To paraphrase the great investor Bernard Baruch – the key to building wealth over the long run is to always sell early! The great financier JP Morgan put it in a similar way on being asked the reason for his financial success – “my approach to the market is to play the middle half of its moves”.
In terms of the current market, I continue to believe that long-dated US Treasuries offer exceptional value from a 6-month horizon with current yields at 4.30% - the ETF ZROZ, which invests in long-dated zeros, is currently trading at 73 (after having gone down to 69 last week) and has the potential to move towards 100 over the course of 2011. The US$ has, as expected, commenced its appreciation versus the Euro and is likely to continue to do so into the early part of 2011. Expectations of further QE programmes are likely to cause sharp reversals in the US$, followed by periods of steady appreciation. Select EM equity markets are likely to be the main beneficiaries of QE programmes, while grappling with high domestic inflation and real (and some nominal) currency appreciation.
I have a penchant for long term charts which exhibit interesting trends in the market – I attach one below from a Sean Corrigan (via Big Picture) which shows the S&P 500 adjusted for the USD Effective Exchange Rate via the BIS index (i.e. in real hard currency terms). It depicts the alternating 50% +/- moves in the index since the LTCM crisis in Aug’98 – and with the +45.3% move up from Feb ’09 until April ’10, the index is due a 50% fall by about 2013! My view is that there is likely to be another surge over the next year or so, followed by a final downdraft into the 2014-2016 periods.
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