Volume 2.13 Increasing Risks Aug 27 2010

VOLUME 2.
13
AUGUST 27, 2010
Increasing Risks
The artificial nature of the U.S. economic recovery from the recession lows has
always been obvious. In recent months, judging from media coverage, it is now
mainstream. While there are a few lingering signs that support some modest optimism,
it is getting difficult to find much to cheer about. In our letter Vol. 2.10, The Artificial
Economic Recovery, dated July 23, 2010 we pointed out that the U.S. growth trajectory
was converging on 1% p.a. With revisions to second quarter GDP that seems to be fact
now. A double-dip U.S. recession is still not a done deal but forces are all on the side of
economic weakness and deflation, and a double-dip recession next year carries a
significant possibility.1
Charts 1-3 show how the weak recovery in employment and production
prospects and the stability in housing have all gone into reverse in spite of zero interest
rates. This is highly unusual, to say the least, after only five quarters of economic
recovery. The message is clear: the policy stimulus provided only a short-term boost.
1
See Brian Reading, Contributing Editor, Boeckh Investment Letter, Vol. 2.11, August 2, 2010, Roller Coaster
Economics: Prepare for the Next Downturn. In the pages below, we elaborate on some of the themes he raised as
well as some others.

© BOECKH INVESTMENTS INC., 1750‐1002 SHERBROOKE STREET WEST, MONTREAL, QUEBEC. H3A 3L6 TEL. 514‐904‐0551, INFO@BCCL.CA
CHART 1 CHART 2
PHILADELPHIA FED DIFFUSION INDEX MFG

Latest: 15/08/2010
40 40
30 30
20 20
10 10
0 0
-10 -10
-20 -20
-30 -30
-40 -40
2005 2010
Source: Thomson Reuters Datastream
CHART 3
EXISTING HOME SALES

Latest: 15/07/2010 (Thousand)
6500 6500
6000 6000
5500 5500
5000 5000
4500 4500
4000 4000
3500 3500
3000 3000
2005 2010
It is clear that there is one global market place for goods, services and money.
And the world has become, once again, structurally very unbalanced and hence, fragile,
as pointed out in our Letter dated August 2, 2010, Volume 2.11, Roller Coaster
©THE BOECKH INVESTMENT LETTER WWW.BOECKHINVESTMENTLETTER.COM 2
Economics: Prepare for the Next Downturn, and discussed at length in The Great
Reflation.2
For many years prior to 2008, there was a precarious disequilibrium requiring a
delicate balancing act to keep things afloat. The crash demolished this artificial world
and created another one via the greatest peacetime global reflation in history. In the
vernacular, we describe this as trying to pump air back into the burst balloon.
Many would argue that the structural disequilibrium, directly and indirectly, was a
principle cause of the crash. We are now heading back in that same direction—growing
surpluses in China, Germany and Japan (Charts 4-6) and the counterpart, growing
deficits in the U.S. and other weak debtor and deficit nations. This is a recipe for
disaster because the deficit countries do not have the internal and external balance
sheets to absorb the excess savings in the rest of the world. Rather than leveraging up
their balance sheets, as they once did to consume, they are deleveraging under the
pressure of markets to get liquid. When everyone tries to get liquid, either by saving
more and spending less, or by trying to get others to buy their goods (in order to get
their liquidity), the result inevitably is that liquidity shrinks in the key areas where it is
most needed.
2
J. Anthony Boeckh, The Great Reflation (Hoboken, NJ: John Wiley & Sons, April 2010)
CHART 4 CHART 5
CHINA: EXPORTS GERMANY: EXPORTS
Latest: 15/07/2010 (USD Billions S.A.) Latest: 15/06/2010 (EURO Billions S.A.)
140 140 9 9
120 120
8 8
100 100
7 7
80 80
60 60
6 6
40 40
5 5
20 20
0 0 4 4
2005 2010 2005 2010
Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream
CHART 6 CHART 7
U.S. PRIVATE SECTOR DEBT TO GDP RATIO

31/03/2010
1.2 1.2
1.0 1.0
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0.0 0.0
1950 1960 1970 1980 1990 2000 2010
In the U.S., deleveraging in the household sector (Chart 7) has barely begun in
spite of a surge in the savings rate, yet the U.S. trade deficit has widened dramatically
(Chart 8). The counterpart is an explosive growth in exports of surplus countries like
China, Germany and Japan. Chart 9 shows China’s surging trade balance.
CHART 8 CHART 9
The most egregious offender is mercantilist China Inc., with its enormously
undervalued exchange rate, loan subsidies to exporters and a variety of other import
restricting / export subsidizing policies. Its dramatic foreign exchange reserve growth in
recent years reflects these policies. The resulting addition to Chinese liquidity feeds
real estate bubbles (but not yet the stock market in this cycle). China does try to
sterilize the monetary effects of reserve accumulation but it is not easy to do on a
sustainable basis.
Effectively, the surplus countries are stealing growth from the deficit countries
and not allowing them to adjust to external and internal disequilibrium. In the U.S., this
can be seen most clearly by the simultaneous rise in the savings rate, the trade deficit
and the deterioration in labor market data. When the natural forces of the adjustment
process to economic disequilibrium are blocked, political tension must necessarily
increase. In an election year, you can expect vulnerable politicians to act.
The options in this situation for a country like the U.S. are limited and not very
good. Apart from further pushing on the monetary string (alias quantitative easing,
formerly known as money printing), there is the possibility of more fiscal stimulus. With
the U.S. government debt:GDP ratio already heading toward 100 by the end of the
decade, this is a dangerous option and unlikely to buy much growth, nor for very long.
However, politicians in the U.S. have never been known to worry too much about the
longer run.
The third option is for the U.S. to opt for non-market solutions—tit-for-tat
mercantilism—to boost domestic demand and employment at the expense of foreigners.
Trade protection can be employed via competitive devaluation, tariffs, non-tariff trade
restrictions, etc. It was last tried in the 1930s when surplus countries didn’t allow deficit
countries to adjust. It would be a far more dangerous option now because the U.S. is a
large foreign debtor. The U.S. has net liabilities of over $3.5 trillion, most of which are
held in short-term instruments by central banks who could try to dump them in
retaliation. The international monetary system is seriously flawed as it was in the
1930s, although there is the important difference that domestic money supplies are not
rigidly linked to central bank holdings of gold or foreign exchange assets. Nonetheless,
great instability with the major reserve asset of the world—dollars—would be
catastrophic.
The options for other debtor countries are far more limited than for the U.S.
Deficit countries in the euro area are currently being forced into fiscal austerity. More
government spending and tax cuts are not going to happen. Nor do these countries
have a monetary/competitive devaluation weapon in their tool box. By default, that
leaves deflation, declining incomes and high unemployment (20% in Spain with Greece
heading there) as the logical outcome. When social tensions reach the breaking point,
trade protection will be seen as an alternative. In more extreme circumstances, some
countries might depart from the euro, create their own currency and massively devalue.
The result would be high inflation and chaos.
Apart from the U.S. and countries in the euro area, there are a variety of others
with finances and economies in various states of disarray. The U.K., one of the larger
ones, has gambled on major fiscal deflation. Even with major cutbacks, some
forecasters such as Moody’s see U.K. debt spiraling up to 90% of GDP in three years.
Japan, after 20 years of stagnation, has a government debt:GDP ratio over 200%. How
Japan has managed to avoid a sovereign debt crisis for so long is a mystery, only partly
explained by its formerly high personal savings rate. This has been falling in recent
years, although a surge in corporate savings has kept total savings at the national level
very high. With dismal growth prospects and rapidly deteriorating demographics, the
overvalued yen is an accident waiting to happen (Chart 10). Most of Eastern Europe is
also in dire straits, propped up with IMF credits. The few bright spots tend to be
commodity producers such as Canada, Australia, Norway and Russia. Nevertheless,
they will have trouble hiding if the world goes protectionist, anti-market and growth
suffers.
CHART 10
JAPANESE YEN EFFECTIVE EXCHANGE RATE

15/07/2010
170 170
160 160
150 150
140 140
130 130
120 120
110 110
2005 2010
These prospects should not be seen as a forecast yet. But the growing tensions
from the deteriorating world economy, the need for sustained, large public and private
deleveraging and the imperative of resolving global disequilibrium must be credibly
addressed without delay. Time is of the essence. The global slowdown is accelerating
and the U.S. faces a key election in 10 weeks. Failure to deal with these issues will
inevitably push the U.S. and other debtor countries into taking action against the surplus
countries to steal back growth. Everyone knows that would be a disaster, but it doesn’t
mean it won’t happen. When options run out, you do what you have to, and that
includes politicians facing voters who are looking for quick and easy solutions.
The key for investors is to understand that adjustments will happen. The process
of trying to get a positive resolution will be messy, fraught with belligerent threats on all
sides and, as always, it will be a nail biting, bluffmanship, go to the matt set of
negotiations. Failure is not an insignificant probability.
Investment Conclusions
The uncertainty described above necessarily creates a very nervous environment
for investors. Money does not like such uncertainty. Investors, more than ever, will
have to grapple with these issues, having no clear idea how it will play out.
In the case of the U.S., politicians are returning from summer holidays to face a
surly electorate. They must deal with deteriorating employment, production and
housing conditions and a wobbly stock market. Policy change is inevitable within the
constraints of a Republican/Democrat partisanship.
Federal Reserve resumption of quantitative easing, (i.e., buying bonds and
mortgages) to inflate its balance sheet further is inevitable (Chart11). As the Fed’s
balance sheet increases, banks will get more reserves, but continuing financial
constipation means not much money growth will come out the other end. However, the
action could boost financial markets and confidence for awhile. Voters might also feel
better temporarily.
CHART 11
U.S. FEDERAL RESERVE ASSETS
2500 2500
2000 2000
1500 1500
1000 1000
500 500
2005 2010
Further fiscal stimulus initiatives by the Administration will be exploited by
Republicans on deficit bashing grounds. Therefore, Democrats will have to be creative
to seduce enough Republicans to get the votes they need. Small business subsidies
and housing would seem to be the easiest targets to get quick and popular action.
Protectionist measures are probably inevitable, but in the short term, there will be a lot
more talk than action.
Debt forgiveness on under-water mortgages has been mooted. Another
moratorium on mortgage foreclosures is possible. There are lots of things that could get
congressional support and have a quick impact (i.e., November use-by date) but, like
previous measures, would only buy a little time. After all, 14% of mortgages are in
foreclosure or delinquent. The estimate is that there will be one million foreclosed
homes this year. Without some support, the brief stabilization of housing prices will
end.
As our readers well know, we have emphasized the critical importance of capital
preservation in this volatile, highly uncertain world. Within that conservative context, we
have been relatively bullish on risk assets. We think the time has come to add another
layer of caution to portfolios. The S&P 500 may well remain in an extended trading
range but we may be much closer to the upper boundary than the lower. Seasonally,
we are heading into a period when markets tend to be weak, and some important
declines have occurred.
At this point, an extended bear market is unlikely, though possible. Corporate
liquidity and profits have been, and still are, a good source of strength. But that is
yesterday’s news. Analysts always lag behind when profits are peaking and that could
well be the case now with the rapid slowing of the economy. However, the market is not
expensive on a long-term basis.
The explosive rally in Treasury bonds has created an interesting situation in
several ways. The 10-year yield is down about 100 basis points to 2¾% and the 10-
year TIPS (real, inflation adjusted) yield has fallen from 1.7% to 1% over the last few
months (Chart 12). It is at a record low and compares with the 2.1% dividend yield in
the S&P. While most people compare nominal bond yields with dividend yields, the
conceptually correct comparison is with real bond yields because dividend yields are
“inflation adjusted” over time. The comparison shows that, if real bond yields remain
low, stocks are cheap on this basis. The observant reader will note, however, that the
last time real rates were this low was in early 2008, just before the stock market tanked.
But that coincided with a move to over 3% in TIPS yields. A repeat anytime soon is
unlikely.
CHART 12 CHART 13
It should also be remembered that low and falling real interest rates are bullish
for gold. The recent decline in the real rate of interest has certainly supported gold
prices. But it is useful to note that gold has essentially gone sideways in recent months
(Chart 13) in spite of this tailwind of falling rates and the publicity surrounding huge
purchases of gold by several very high profile hedge funds and massive purchases by
retail investors.
Clearly, a sharp rise in real interest rates would be a major negative for both
asset classes. At some point, real interest rates will rise, either because deflation sets
in3 or because the Treasury will have trouble selling its bonds as fears heighten over
rising debt levels. It is unlikely to happen for some time.
Putting all this together, it is clear that there are cross-currents that will continue
to affect the equity market and we prefer to shift toward more caution. Uncertainty will
continue to grow and plenty can go wrong on short notice. On the other hand, it is hard
to see where the positives might come from, other than another politically motivated
reckless reflation effort from the U.S. authorities. We use the term reckless in a long-
term sense. The U.S. simply does not have good options. Therefore, it will use the
tools it has, trading off short-term benefits for long-term risks. There is nothing new in
that!
Gold remains an enigma. It is still in a bull market, but one that seems to be
losing momentum. It is a highly popular, well-advertised asset and has become very
expensive relative to almost all other assets. It is, however, a demonstrated hedge
against financial meltdown and, as such, deserves an insurance role of 5-10% in
portfolios. But it is very expensive insurance; it will be volatile and could be a very poor
performer if instability fears abate.
Miscellaneous Thoughts:
 The sharp move up in bond prices in recent months in reaction to the well-
3
Price inflation can become negative but nominal rates cannot fall below zero.
publicized economic slowdown makes bonds vulnerable on a short-term basis.
However, long-term investors should continue to hold positions because bonds
are doing what they are supposed to—provide safe income and a hedge against
deflation. As a result they are a very good portfolio diversifier in this
environment. Five and ten-year TIPS are poor value at near zero and 1% yields
respectively. Twenty-year TIPS are much better at 1.7% yield but they are at the
low end of their range and hence vulnerable.
 Credit spreads have narrowed and do not provide much value unless skillfully
chosen. Junk bonds will experience increased risk as the economy deteriorates.
 The U.S. dollar should continue to weaken as further Fed balance sheet
expansion occurs.
 Commodities (including oil) have more downside than upside potential as the
economy slows further. However, the China slowdown is now a fact (Chart 14).
Price inflation has eased sharply (Chart 15), the housing bubble has been
pricked and exports are surging. Look for China to reverse monetary tightening,
the stock market to increase and demand for commodities to start rising again.
CHART 14 CHART 15
CHINA: LEADING INDICATOR CHINA: PRODUCER PRICE INDEX

15/07/2010 Latest: 15/07/2010 (Annualized % Change Q/Q)
106 106 60 60
104 104 40 40
102 102 20 20
100 100 0 0
98 98 -20 -20
96 96 -40 -40
2005 2010 2005 2010
Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream
 The controversial Australian mining tax is worth paying attention to by global
investors who favor the resource sector as a long-term bullish play on world
competition for these assets. While the ruling party in Australia lost seats in the
recent election, the tax is not dead and has many supporters. In a world of
desperate governments hungry for tax revenues, fat profits of resource
companies are a tempting target. The old argument that such profits are a
windfall on a depleting asset would play well to a large part of any electorate.
 Canada went through predatory government action against resource companies
in the 1970s and again in Alberta a few years ago with an ill-fated increased
royalty tax on energy. A left-leaning government in the future may well be
tempted again.
 While Canada has deservedly had a good ride in recent years particularly
through the global recession, due to strong Federal Government finances and a
strong balance sheet, all is not quite as rosy as meets the eye. Chart 16 shows
that, while the U.S. savings rate has gone from 2% to 6.5% since 2007, the
Canadian savings rate, after a brief rally, has collapsed to about 2 1/2%.
Canadian households have continued to add to their debt, oblivious to the
changed world environment. House prices rose to new highs during the
recovery, while U.S. house prices are down over 30% from their peak.
Moreover, while federal debt levels and trends are good by world standards,
provincial debts are disastrous. There is even some talk of Ontario going the
way of California. Its per capita public debt is ten times that of California whose
bonds are rated slightly less risky than Croatia’s.4
CHART 16
4
Neil Reynolds, Ontario, Not Unlike California, is Going for Broke, (Toronto Globe & Mail, August 25, 2010:
B2).
In summary, continue to focus on wealth preservation. Increased caution is
warranted.
Tony Boeckh / Rob Boeckh
Date: August 27, 2010
www.BoeckhInvestmentLetter.com
info@bccl.ca
New Book by J. Anthony Boeckh

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VOLUME 2.

PHILADELPHIA FED DIFFUSION INDEX MFG

EXISTING HOME SALES

U.S. PRIVATE SECTOR DEBT TO GDP RATIO

sterilize the monetary effects of reserve accumulation but it is not easy to do on a

increase. In an election year, you can expect vulnerable politicians to act.

mercantilism—to boost domestic demand and employment at the expense of foreigners.

retaliation. The international monetary system is seriously flawed as it was in the

great instability with the major reserve asset of the world—dollars—would be

have a monetary/competitive devaluation weapon in their tool box. By default, that

trade protection will be seen as an alternative. In more extreme circumstances, some

The result would be high inflation and chaos.

commodity producers such as Canada, Australia, Norway and Russia. Nevertheless,

JAPANESE YEN EFFECTIVE EXCHANGE RATE

deleveraging and the imperative of resolving global disequilibrium must be credibly

negotiations. Failure is not an insignificant probability.

The uncertainty described above necessarily creates a very nervous environment

constraints of a Republican/Democrat partisanship.

Federal Reserve resumption of quantitative easing, (i.e., buying bonds and

Further fiscal stimulus initiatives by the Administration will be exploited by

Republicans on deficit bashing grounds. Therefore, Democrats will have to be creative

more talk than action.

Debt forgiveness on under-water mortgages has been mooted. Another

declines have occurred.

At this point, an extended bear market is unlikely, though possible. Corporate

expensive on a long-term basis.

The explosive rally in Treasury bonds has created an interesting situation in

rising debt levels. It is unlikely to happen for some time.

against financial meltdown and, as such, deserves an insurance role of 5-10% in

performer if instability fears abate.

However, long-term investors should continue to hold positions because bonds

deflation. As a result they are a very good portfolio diversifier in this

low end of their range and hence vulnerable.

CHINA: LEADING INDICATOR CHINA: PRODUCER PRICE INDEX

 The controversial Australian mining tax is worth paying attention to by global

desperate governments hungry for tax revenues, fat profits of resource

 Canada went through predatory government action against resource companies

royalty tax on energy. A left-leaning government in the future may well be

Canadian households have continued to add to their debt, oblivious to the

bonds are rated slightly less risky than Croatia’s.4

Tony Boeckh / Rob Boeckh

Date: August 27, 2010

New Book by J. Anthony Boeckh

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