David Rosenberg's Latest

Hello Everyone!

Take a look at the latest economic report from Merrill Lynch's David Rosenberg. He is the best economist out there and completly nails everything in my opinion. Note that the losses in household wealth have now risen to $13 trillion dollars. Incredible.

Anyway Enjoy!

"Where can things go wrong in 2009?

All of a sudden, we are asked frequently as to whether we are now excessively bearish on the 2009 outlook, and what will cause us to change our mind. It’s rather amazing what a 20% bear market rally in equities, from a 12-year low in the S&P 500 that nobody ever saw coming to begin with, can do to alter perceptions about the entire year-ahead.

The consensus a year ago, and where we are today

A year ago, the widespread consensus was (1) the economy was in a soft patch; (2) the equity market was in a classic corrective phase; and (3) the Fed was nearly done cutting rates and bonds were a sell. Today, we are coming off lower levels of everything, but the common thread of renewed economic growth, bull market in equities and sell recommendations on Treasuries remains intact. To wit:

1) Consensus sees a second half economic rebound The economics community sees the recession ending as soon as 2Q09 and then a fiscally-led second-half economic rebound in real GDP: 1Q09 is pegged at -2.4% (at a seasonally adjusted annual rate), 2Q at -0.5%, 3Q at + 1.3%, and 4Q at +1.8% (as an aside, we do not see a positive print until 1Q10 at the earliest). This time last year, the consensus was calling for 1.3% annualized growth for 1Q08 (the actual was 0.9%), 1.9% for 2Q08 (actual was 2.8%), 2.3% for 3Q08 (actual was -0.5%), and 2.6% for 4Q08 (looks like it will be -6% or possibly worse). So, do you detect a pattern? Economists tend to build a story that things will always progressively get better every year and the irony is that the quarter that they thought was going to be the best in 2008 (the fourth quarter), turned out to be the worst.

2) No one is calling for another down year in equities The equity strategists in the latest Barron’s Roundtable collectively see 1,045 on the S&P 500 by year-end. Nobody is calling for another down year. We had this exact same situation a year ago when the Roundtable forecast was 1,640 on the S&P 500 for the end of 2008 (it closed at 903 – the experts as a group were only off by 45%).

3) Bond watchers bearishThe bond-watchers see the 10-year note surging nearly a percentage point to 3% on average. In the Barron's survey at the end of 2007, the consensus forecast was 3.8% for the Fed funds rate for the end of 2008 and get this – the consensus was 4-1/2% for the 10-year T-note (it closed at 2.2% -- the consensus was off by over 200 basis points!).

The risk is that the consensus may be wrong yet again

So, the answer is quite simple when asked the question where things can go wrong in 2009. Maybe the risk is that, yet again, the consensus will get it wrong just as this time last year in terms of being too high on economic growth, equity valuation and bond yields.

Household wealth declining at an unprecedented rate

What many pundits still do not seem to get is that as of 3Q08, over $7 trillion of household net worth dissolved over the prior year for an 11% plunge. We estimate that the cumulative loss of household wealth as of 4Q was probably north of $13 trillion based on what home prices and equity valuations did since the end of September. This would bring the total loss to over a 20% decline from the peak of mid-2007, which is unprecedented in the post-war era. To be sure, the 2001 tech bubble bursting was no picnic, but the peak-to-trough decline in household net worth back then was $4.2 trillion, or a 9.6% decline. In the 1975 deflation in asset values (this period represented the worst economic backdrop of the past five decades), the peak-to-trough decline was $160 billion, or -3.6% in household net worth.

Shock on personal savings rate will be substantial

As Chart 1 on household wealth strongly suggests, we are in a whole new zone where the good old-fashioned macroeconomic models are at risk of yielding the same flawed results as they did in 2008. We are coming off a record implosion of household net worth, and history shows there to be a 90% historical correlation between that and the personal savings rate, which is now on a discernible uptrend. The lagged impact from the unprecedented negative wealth shock on the personal savings rate is likely to be substantial and as we have said time and again, expectations that the Fed, Treasury or Congress have some magic wand are wholly unrealistic. At best, the aggressive policy stimulus will cushion the blow.

Aggressive stimulus will only cushion the blow

The Fed’s balance sheet has expanded to over $2 trillion and may soon exceed $3 trillion as the central bank plays the role of lender of last resort, not just for the Wall Street but for Main Street too. In addition, the Obama team may well be planning as much as a two-year, $850 billion fiscal plan. However, it is important to understand that these cushions are dwarfed by the aggregate wealth loss of $13 trillion posted so far (and this is far from over yet).

Aggressive stimulus will only cushion the blow

The Fed’s balance sheet has expanded to over $2 trillion and may soon exceed $3 trillion as the central bank plays the role of lender of last resort, not just for the Wall Street but for Main Street too. In addition, the Obama team may well be planning as much as a two-year, $850 billion fiscal plan. However, it is important to understand that these cushions are dwarfed by the aggregate wealth loss of $13 trillion posted so far (and this is far from over yet).

Process of saving more out of current income will intensify

To reiterate, this plunge in household net worth is virtually unprecedented and the lingering impact this is going to exert on household savings and spending patterns is going to be big story of 2009. What the decline in asset values means is that households, which have already begun the process of saving more out of current income, will intensify those efforts – especially among the boomers who are nearing retirement age.

A $1 trillion total drag on GDP

By our estimation, this trend toward income-based savings as opposed to asset-based savings is going to come at the expense of discretionary consumer spending, and could end up draining as much as $350 billion out of GDP in 2009. On top of that, the direct impact of job loss on personal income and the indirect impact on wages as the unemployment rate rises to new highs of over 8% will result in additional $650 billion negative swing on spending this year compared with the baseline trend in 2008, based on our our research. That is a $1 trillion total drag on GDP from the dual impact on consumer spending from the negative wealth effect on savings and the deterioration in the labor market on income.

To be sure, if energy prices can manage to stabilize near their current levels in 2009, that would help provide a cash-flow offset of $125 billion, but would still leave a spending hole of roughly $875 billion. We’re not convinced that the federal government is going to be able to totally offset that contraction in spending in just one year.

Attitudes toward spending and debt have shifted

The reality, and this is just common sense, is that the marginal household is going to expend all its resources to ensure that monthly housing payments are met, that there is enough food on the table for the family, that the children’s education needs are looked after, and that the depleted retirement nest-egg is replenished. It still seems lost on so many pundits that there has been a generational change in terms of how households, at the margin, are allocating their budgets toward discretionary spending and how they are approaching the concept of credit. Attitudes toward non-essential spending and debt have changed; this is not just a cyclical development, but more likely a secular shift. The 2001-07 experience of no-doc loans, 0% financing, option ARMs and subprime credit has proven to be a nightmare for the marginal household.

Demand for credit remains weak

There is more than enough survey evidence from the Fed to show that it is not just the supply of credit that has tightened dramatically, but household demand for personal loans and residential mortgages has scarcely been as weak as today, despite the plunge in interest rates. Housing demand has continued to collapse even though homeowner affordability ratios are at their best levels in four decades. At the margin, people would rather rent than take on a mortgage to service a deflating asset.

Housing deflation has actually intensified

The Keynesian-influenced Obama economics team is planning a huge fiscal package that is likely to be legislated and signed in coming weeks. The selling pressure may have abated for the time being in the equity market (though it is not clear to us that the bear phase is complete), but the deflation in housing (real estate is twice as large an asset on the household balance sheet) has actually intensified over the past 3-4 months as the unsold new and existing inventory has reached new cycle highs.

Data points of post WWII era are of limited use

So, there is still substantial asset deflation, job losses continue to mount, and many companies are now facing severe shortfalls in their pension funds. This is going to require higher employee contribution rates and/or reduced benefits. A growing number of firms are also eliminating their matched 401k contributions for their workers. This will likely reinforce the trend toward higher personal savings rates going forward. As time goes by, it is becoming increasingly apparent that the data points of the post-WWII era are of limited use in forecasting through an epic collapse in credit and asset values. Ben Bernanke realizes this, which is why he no longer relies on classic monetary policy measures that helped revive the economy through the inventory-induced recessions of the past five decades.

A good sense of history is needed to tweak the forecast

This is not to say that we have abandoned our macro models, but in times like this, sound judgment and a good sense of history are necessary ‘tweaking’ ingredients in the economic forecast. Of all the books we read over the holiday season, the one that resonated the most was “The Great Wave: Price Revolutions and The Rhythm of History” by David Hackett Fischer. It is a true masterpiece that examines price revolutions back to the twelfth century. While they all differ in terms of duration and intensity, they share a “common wave structure” and “succeeded one another in a continuous sequence of historical change.” He adds “the study of history can never tell us what will happen next, but it gives us the benefit of much hard-won experience in the past”. http://csmres.jmu.edu/geollab/Fichter/GS....

With that in mind, we find that most economists are hinging their forecasts of a second half economic recovery on repeated bouts of government stimulus. But the benefit of history, as Fischer aptly points out, is that “monetary and fiscal tools,” while described as being “powerful weapons” are at the same time “very blunt and crude” and often “counterproductive” (as any impartial analysis of the New Deal will attest). And, Fischer makes the claim, again based on centuries of past experience that the “side effects” from government intervention are sometimes worse than the problems they are meant to solve.

Policy measures no match for a credit contraction

We are not quite as convinced as the rest of the economics community that the rounds of stimulus and government incursion into the economy and capital market are going to do much more than cushion the blow from the ongoing recession in the private sector. It is essential to realize that all the liquidity being created by the Federal Reserve and deficit spending by the federal government cannot be assessed in a vacuum. The policy measures, while increasingly aggressive, are still no match for the contraction of credit and the record deflation in asset values being incurred by the American household, which represents 70% of GDP and nearly 20% of the global economy. This is the reality that the bond bears and inflation-phobes are going to find themselves coping with in 2009 and perhaps into 2010 as well, in our opinion.


Deflation will be a more enduring theme than many realize

It is perfectly understandable to us, but still dangerous, to be clueless about the mechanism that determines whether we experience inflation or deflation. Even with the upcoming stimulus, this economy, which has been growing below potential since June 2006, will very likely continue to do so this year and well into next year as well. This means a sustained widening in the output gap. In other words, growth in available supply exceeding aggregate demand, higher unemployment rates and lower capacity utilization rates, are likely to be a reality as far as the eye can see. The deflation story is going to prove to be a much more enduring theme than many realize, in our view.

At least another 15% downside to home prices

To be sure, there is currently a healthy debate as to whether the equity market has hit a fundamental bottom. The selling pressure peaked in October-November, but we remain skeptical since our own metrics suggest that we are barely past the 40% mark of this recession, and the equity market typically bottoms 60% of the way through. But even if we are wrong in our bearish assessment of the equity market, we remain convinced that there is at least another 15% downside to nationwide home prices as the problems on the coasts migrate to the financial centers in the Northeast. The latest data were horrific, despite the fact that the builders have taken new construction schedules to all-time lows, demand for housing is so moribund that the total inventory overhang has risen above 11 months’ supply in both the market for new and existing homes. This is nearly double a typically well-balanced market and is a sure sign to us that real estate deflation will remain an enduring theme and a constant drag on confidence, credit, net worth, credit and discretionary spending.



Rising savings rate acts as a drag on discretionary spending

Lingering house price deflation would also ensure that the savings rate remains on a secular uptrend. This would be a dead-weight drag on consumer discretionary spending, but may actually end up being good news for municipal bonds and high-grade corporate bonds since the boomers will be craving relatively safe income-generating securities during this expansion of the personal savings pool; 0%-yielding cash is not an option, in our view, and we wonder aloud how investor appetite for equities is going to be whetted because the painful memory of two major bear markets seven years apart is not likely to fade anytime soon.


Switch out of deflation hinges on a positive credit cycle

As house prices continue to deflate, the ability on the part of private lenders to extend credit likely will remain impaired as more losses become exposed and write-downs are taken, and few households are going to be willing to borrow in order to finance an asset that is in a secular deflation (based on our macro forecast, total credit losses will come to $2 trillion this cycle, so it is tough to make the assertion that we are even past the half-way mark on the write-down phase). While the Fed will continue to boost the supply of money, we are not convinced that velocity will reaccelerate in time to generate a return to inflation in 2009 or 2010. The switch out of a deflationary backdrop, as we saw in 2003, hinges on a return to a positive credit cycle, which is a proposition we find untenable considering that the aggregate level of private sector debt relative to GDP is still near a historic peak of 172%, and only began to correct in 1Q of last year.

Process of unwinding excess credit is very deflationary

As Chart 2 illustrates, this household and business debt/income ratio is still 50 percentage points above the long-run pre-bubble norm. So, it is difficult to believe that we can actually embark on a new credit cycle when the level of outstanding private sector debt remains $6 trillion beyond the bounds of what the economy has traditionally been capable of handling.

Deflation cycle may have another two years to go

As we saw in the past year, the process of unwinding this excess credit is enormously deflationary, and the Fed, Treasury, Congress and the incoming Obama team have the daunting task of ensuring that this transition phase toward debt elimination is as orderly as possible. Their job is to promote social stability during this deflationary period, which is why bailouts have become a regular event. Our job is to forecast the future for our clients as best to our ability. Interest rate forecasting and GDP forecasting hinges, and corporate profit forecasting critically hinges, on the outlook for prices. If history is any guide, this deflation cycle may have another two years to go, and that assumes there are no significant policy missteps along the way."