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Taken in isolation, it is
true, as some have argued in our hearing, that the US housing market is not the
be-all-and-end-all of the nation’s economic capabilities. We have
always been at pains to emphasise the towering scale and predominant role of
overall business spending in comparison to this and, as but one specific
example, we have spent a good eighteen months showing charts of the concomitant
rise in non-residential construction outlays and payrolls as a case of a
reallocation of a fairly interchangeable group of ‘factors’, as
the impetus of Inflation has switched between the two sectors.
Alas, that counterpoise may
now be swinging to the same, lowered side of the balance arm. The sorry state
of CMBS (Commercial Mortgage Backed Securities)spreads
bodes ill for future construction finance while commercial property prices
seem to be flagging after an impressive bull run in both the US and the UK. Not only are the newspapers
beginning to report rumblings in the market of project cancellations and repricings, but the unease can only deepen if we take the
latest, far more stringent Fed Loan Officers survey at face value.
If we pay heed to the
unusually rapid deterioration in state and municipal finances (and hence the
reduction likely to follow in their building budgets); if we note the sharp
loss of confidence among NFIB small business members; and if we realize that
the bio-ethanol racket is in imminent danger of becoming yet another New Deal
programme gone spectacularly awry.
But, beyond this, what we
have repeatedly cautioned is that
the real danger inherent in housing is exactly the one which is now unfolding
— namely, that it represents nothing more than the ragged edge of an
vast, hemispheric storm system of horribly malinvested
capital and negligently granted credit which has quietly been brewing far out
over the steamy, tropical ocean of Inflation, but which is now rushing
terrifyingly shorewards.
Turning to the semantics
again, we are beginning to find the term ‘sub-prime’ not only
annoyingly clichéd, but actually of as little worth as are the loans
so-designated, for, in order that this characterisation should have any
meaning at all, there must be a ‘prime’ in relation to which the
offending category is ‘sub’ and that, in itself, is becoming a
premise of increasing doubtfulness.
What, after all, is
‘prime’ in a world when the biggest and brightest banks have so patently
Chuck Prince-polka’ed (In honour of the
ex-Citigroup chief whose eve-of-crash remarks about his firm’s
involvement in the mania was truly Greek in its timing) themselves to exhaustion?
What is ‘prime’ in a world where default
spreads are going stratospheric for the very companies whose financial
integrity is supposed to insure the credit worthiness of a multi-trillion tranche of debt? What is ‘prime’ when the
shares of the GSEs (Government-Sponsored
Enterprises, essentially Fannie Mae & Freddie Mac), the main guarantors
of the ostensibly better class of mortgage credit, are in freefall, having
already squandered all credibility with a series of accounting scandals
during the boom years and thus having no reserves of trust upon which to draw
in their present difficulties?
What is ‘prime’
in a world where the very money market funds to which the Forgotten Man turns
when he seeks a safe haven are chock full of the same poisonous garbage causing problems elsewhere – a sorry state of
affairs brought about by a deplorable lack of stewardship on the part of
managers either running unacceptable risks for the most trifling of extra
rewards or culpable of an outright conflict of interest in passively
accepting such credits straight from the sausage
factories of their firms’ origination departments?
What is ‘prime’
in a world where record share of a record volume of debt issuance has been
conducted at record low spreads, with record loose covenants, and at
multi-decade low real rates – a self-fuelling process which has helped
deliver extraordinarily low corporate default
rates by enabling sub-marginal businesses to postpone the day of reckoning by
means of a succession of judicious refinancings,
exactly like an overburdened homeowner rolling up his P&I payments each
and every month?
Such a lowly level of defaults may well have seemed to endorse the low risk
premia being demanded as recently as this summer,
but this same feedback is likely to show an equalling self-exacerbating (but
inevitably more vertiginous) reversal now that the fat lady has, at last,
begun to warble.
Yesterday once more
As we have repeatedly
warned, the credit cycle IS the business cycle and with the first having
ploughed so disastrously through the crash barrier it is inconceivable that the
second can stay on the track. An Austrian maxim is that a treatment of the
cycle may well start as a monetary problem, but that it always ends up as a
real one. Here we would note some uncomfortable parallels with the late
1920s/early 1930s.
Though history often
forgets this, Jazz Age exuberance did not just express itself in the steep
rise on Wall St, but also in the granting of copious loans by creditor
America to debtor Europe and Latin America where it was used in a highly
unproductive fashion to build apartment blocks and municipal swimming pools,
as well as to support ailing industries and stabilise commodity prices. When
this flood was suddenly staunched
as the Young negotiations became bogged down in 1928, it caused the hot money to rush back home where it
boosted the Dow to the unsustainable heights of 1929, in outright
defiance of contemporaneous moves by the central bank to reduce the liquidity
pouring into stocks.
As the credit-starved
foreigner consumers were forced to draw in their horns, however, US exports
started to fall off and domestic output started to cool, driving a fatal
wedge between soaring stock prices and faltering business performance.
Furthermore, as the indebted were severely restricted in the volume of trade
goods they could remit in payment of their debts — thanks to a
spectacularly ill-advised tariff policy — they began to bleed gold as a
consequence, tightening the monetary vice further.
At last, the strain became
too much and their banks began to freeze up, culminating in the devastating
1931 collapse of Austria’s giant Creditanstalt,
itself mortally weakened through having been used previously as a rescue
vehicle by the government of the day. In the upheaval which followed, the UK reneged on
its adherence to gold, causing
incalculable losses to holders of sterling reserves and provoking a further
credit squeeze. The attempt to alleviate this ushered in a disruptive round
of competing currency devaluations around the globe and turned the stock
market crash into a deep, worldwide depression.
If we reverse the positions
of the US and Eurasia and think of a gold drain then as a rush from the
dollar today (conflating the current US administration’s malign neglect
of the world’s reserve currency with the then-British government’s
pusillanimity in cutting sterling loose), we can get all the way to the Creditanstalt episode — for whose present analogue
we are not lacking in likely candidates from which to choose.
Knowing this, however, and
being aware that the Fed is currently headed by a Depression Era buff (if one
whose neo-Keynesian orthodoxy has led him to derive all the wrong conclusions
from his studies), we can fully expect that these resonances will be all too
apparent to policy makers and that they will be ready to take drastic and
pre-emptive action at a moment’s notice in order to avoid a full re-run
of the scenario they all dread so much.
Right back where I started
from
Therefore, with the scale
of the credit disaster potentially so enormous, there would seem to be only
one course of action open to the authorities,
however misguided this will be in terms of perpetuating the cause of our woes, not expunging them.
Firstly, we should expect
short term rates to be slashed in order to steepen
the yield curve and ease banks’ financing costs, while simultaneously
tempting dollar-shy foreigners to buy currency-hedged US assets by
means of cheap, short-dated loans.
Secondly, a sizeable slug
of the sour credit will have to be repackaged and co-opted by a government
which will promptly run much larger budget deficits (perhaps compounding this
fiscal loosening with the electorally attractive
expedient of greater tax breaks for property owners).
When seeking to issue more
Treasury notes against the junk, the Federal government will find it
convenient that the Fed (and the Basel rules) A protocol under the auspices of the Bank for International Settlements
laying out how much capital banks must hold against various classes of
assets. Needless to say, higher-rated government debt, issued in local
currency, comes in at zero) will have already made them into a suitably rich,
capital requirement-lite, income stream for the
ailing commercial banks, thus helping them rebuild their battered balance
sheets.
No doubt this process will
be augmented by an upsurge in the
mutual back scratching whereby one bank subscribes to a
‘capital’-raising issue from a peer in the full expectation of
receiving both a larger credit line and a swift quid pro quo when it comes to
the market on its own account. (We put ‘capital’ in inverted
commas to emphasize just how specious this process really is, consisting, as
it does, of little more than a series of offsetting book-entries between
failing fractional reserve franchises).
On the face of it, none of
this would be of much comfort to a dollar which may presently be heavily
oversold, but whose structural weakness is hardly a source of puzzlement.
Lower rates and steeper curves would not only draw in new, currency-neutral
buyers of US assets, but would also see existing holders heavily incentivised to seek protection by selling forward, at
least during the period of overall adjustment.
However, the one thing
which might frustrate the bears is that any further upward pressure on the euro is likely to see to see the ECB capitulate in its
own sham combat with ‘inflation’ (neither must we forget that
European banks may need a little yield curve help of their own, as the crisis
unfolds). If this happens, the Asians will be faced with an imminent
shrinkage in both their prime export markets — rather than having the
one take up the slack provided by the other, as is currently the case. They
will doubtless then respond in time-honoured fashion by seeking ways of
pumping in more of their own currency and pouring prodigious amounts of
concrete as a counter.
Thus, as the Inflationary
boom rolls over into a credit-led slowdown, we are likely to see a radical
shift back to government as the main conduit of the renewed Inflation needed
to keep the banking system afloat and individuals from taking to the streets.
This change of emphasis will not be without its frictions, of course, so a
period of falling profitability, increased joblessness, and sub-par GDP
increase is a distinct possibility (even if this last, flawed measure does
not manage to register the two successive quarterly contractions needed to
qualify – semantically speaking - as an official ‘recession).
However, if Leviathan is to
be the main deficit spender in this next round of Inflation, we can clearly
expect fewer supply-side wonders to accompany its outlays. Political dole
will be directed at buying votes, not enhancing efficiencies, meaning more
power will be ceded to domestic labour — especially in the overgrown
public sector — allowing it to seize a larger share of the proceeds; a
power which will backed up with heightened barriers to trade, if necessary,
as the backlash against ‘globalisation’ intensifies.
Such an outcome means that
the new Inflation is far more likely to degenerate straight into
‘inflation’ — rising consumer goods prices — than the
old one it replaces, disappointing those who automatically
assume that slower growth ensures lower prices, irrespective of the
prevailing monetary conditions. Keynesians — being so verbally hung up
on their narrow concepts of ‘inflation’ — never could get
their heads around the concept of ‘stagflation’.
Financial assets could be
in for a rough ride if this is the case — that is, if the intent to
avoid the icy wastes of the 1930s leads us straight
into the searing desert of the 1970s instead.
Conversely, the experience
of that latter dark decade (the first, too, after 1933) suggests that, after
a further bout of liquidation by the speculative crowd, commodities might
find a second wind, though with a distinct change of dynamic which means
investors would be wise to de-emphasise exposures to primary inputs to
industrial growth (bulk base metals, iron ore, and coking coal) and re-orient
themselves to end-consumables (foods and fuels) and anti-money ‘hoardables’ (precious metals and diamonds).
There would be a certain
grim irony to be had if things do come to this pass for, as the great Richard
Cantillon well understood, nearly three hundred
years ago, Inflation and ‘inflation’ are just as often enemies as
friends and that paper money is ultimately a poor substitute for hard
specie:-
In 1720 the capital of
public stock and of Bubbles which were snares and enterprises of private
companies at London, rose to the value of 800 millions sterling[NB
around £150 billion today, calculated via the gold price of sterling],
yet the purchases and sales of such pestilential stocks were carried on
without difficulty through the quantity of notes of all kinds which were
issued, while the same paper money was accepted in payment of interest.
But as soon as the idea of
great fortunes induced many individuals to increase their expenses, to buy
carriages, foreign linen and silk, cash was needed for all that, I mean for
the expenditure of the interest, and this broke up all the systems.
This example shews the paper and credit of public and private Banks
may cause surprising results in
everything which does not concern ordinary expenditure for drink and food,
clothing, and other family requirements, but that in the regular course of
the circulation the help of Banks and credit of this kind is much smaller and
less solid than is generally supposed.‘Silver
alone is the true sinews of circulation’
Sean
Corrigan
Sean Corrigan is Chief Investment Strategist for Diapason
Commodities Management
Lausanne
& London
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