The Daily Reckoning
Albuquerque, New Mexico
Tuesday, August 03, 2004
The Daily Reckoning PRESENTS: This expert's principal
concern - regarding the U.S. financial and real estate
markets - is precisely that the economy is as strong as
everyone predicts. How can that possibly be? Read on...
A DAMNATION IN DISGUISE
by Marc Faber
If the Fed continues to print money at the rate they have
done in the last couple of weeks, there is a chance - given
that the global economy is, while unbalanced, nevertheless
in a strong synchronized growth mode - that inflationary
pressures could accelerate far more than is currently
expected.
In this instance, inflationary symptoms would show up in
sharply rising wholesale and consumer prices and not
necessarily in rising asset prices, such as real estate. In
other words, inflation would migrate from the asset markets
to consumer prices and lead to far higher interest rates
and, possibly, to a rout in the bond market, as has already
happened in Japan, where JGB bond yields have risen by more
than 300% since June 2003, knocking off bond prices!
Now, in the case of Japan, the more-than-tripling in bond
yields coincided with a strong recovery in the stock market
(up from less than 8,000 in April to around 11,500
recently); therefore, one could argue that, in the United
States, further weakness in bonds, or even a collapsing
bond market, may not derail a bull market in equities.
But there are numerous important differences between Japan
and the United States. For one, I suppose that a rise in
Japanese bond yields from less than 0.5% to 1.9% has hardly
had an impact on the Japanese property market, since
properties have rental yields of 6% or more.
In the United States, however, where rental yields are
frequently below mortgage rates, I suppose that a rise in
mortgage rates from 6% to 18% would have a devastating
impact. (Such a rise in bond yields is, for now,
inconceivable.) Also, when Japanese stocks and interest
rates bottomed out a year ago, expectations in Japan about
future economic growth were extremely depressed, bearish
sentiment was at an extreme, and Japanese institutional
investors and individuals were very underweighted in
equities compared to bonds. Otherwise, how could one
explain that, at the time, the Japanese stock market had a
dividend yield of more than 1.5%, while bonds were yielding
less than 0.5%?
May I remind our readers that in the 1940s, the Dow Jones
Industrial Average had, at times, a dividend yield of 7%,
while government bond yields fell to below 2%, indicating
that growth expectations were then as low as they were last
year in Japan. And in the same way that the 1940s
represented the best short opportunity in one's lifetime
for U.S. bonds, I suppose that investors will never again
see Japanese bond yields of less than 0.5%, and that from
here on, interrupted by trading rallies, Japanese bonds
will continue to decline for the next 10 years or so.
Over the last 12 months, as the bearish sentiment about the
Japanese economy and its stocks began to dissipate, a
massive shift from bonds into equities got under way.
Admittedly, foreign investors largely drove this shift. In
short, because Japan suffered from a severe asset deflation
and a poor economic environment throughout the 1990s and
until just recently, when its bond market bubble was
deflated over the last 12 months, it did not cause any
serious pain in the asset markets as the economy improved
and deflationary forces dissipated. (Still, if interest
rates rise much further in the immediate future, some pain
may be felt - particularly in the banking sector, which
still holds huge bond positions.)
In any event, I hope that the reader will understand the
current fundamentally different conditions between Japan
(which also enjoys a high savings rate and a huge current
account surplus) and the United States, where asset prices
didn't deflate over the past 15 years, as was the case in
Japan, but were instead inflated as a result of
expansionary monetary policies.
Moreover, U.S. stocks have a far lower dividend yield than
long-term bonds (high growth expectations) and households
and financial institutions hold a far higher percentage of
their financial assets in equities than in Japan.
To put it in very simplistic terms, whereas rising global
inflation and interest rates are likely to be beneficial
for the Japanese economy, whose problem was asset
deflation, this is unlikely to be the case for the United
States, where excessive debt growth fuelled asset inflation
and led to a highly leveraged consumer. In fact, my
principal concern regarding the U.S. financial and real
estate markets would be precisely that the economy is as
strong as everyone is predicting.
In this scenario, I wouldn't be surprised to see a
repetition not of 1994, as is popularly supposed, but of
1973/1974, when corporate earnings expanded but stocks fell
out of bed because of rising inflation and interest rates.
(Watergate certainly didn't help, but today's geopolitical
tensions are, in my opinion, far more serious.)
In this respect, it is important to understand the
following.
The Fed can largely control to what extent it wants to
expand the money supply (print money), but it doesn't
control its consequences - that is, where the money flows
to and which sectors of the economy inflate. (Admittedly,
Mr. Greenspan has been able to inflate just about
everything around the world.) Still, one sector that has
not been inflating much, given the global competition for
labor, is wages and salaries of the U.S. labor force.
Therefore, if expansionary monetary policies lead to a rise
in the cost of living (not the CPI, published by the Bureau
of Labor Statistics, which understates for political
reasons the true rate of inflation), then real wages will
continue to decline since cost-of-living increases are more
likely to run at 5-7% per annum while wages are rising at
most by 2-3% per annum. If this were to occur, the
consequence would be that affordability will become a
problem and households will have to reduce the rate at
which they are spending, unless they choose to increase
their borrowing.
But here comes the problem. In this scenario of declining
real earnings but accelerating inflation (read
stagflation), it is likely that the market - not the Fed -
would force interest rates up considerably and that,
therefore, the asset markets (notably real estate) may - if
not decline - at least cease to appreciate at the rate at
which they have done so over the last few years. As a
result, the rate at which the consumer takes on additional
debt will slow down or even decline (should consumers, for
a change, decide to boost their saving rate).
The Federal Reserve Board is caught in a very difficult
position. Continuous excessive money printing may not lead
to a stronger economy but to declining real incomes and
rising interest rates as inflation picks up. Conversely,
resolute tightening moves could easily upset already
overleveraged consumers and lead to a severe adjustment in
the real estate market, whose appreciation has fuelled
consumption since 2000. In fact, it would seem to me that,
regardless of future monetary policies, the economy will
disappoint, as the market mechanism has begun to take away
the Fed's job by tightening monetary conditions.
I might add that the Fed should never have had the
authority to distort the free market for interest rates
through monetary policies. Hopefully, the market mechanism
is now powerful enough to render the Fed's monetary
manipulations irrelevant.
Regards,
Marc Faber,
for The Daily Reckoning