More than Just Lines on a Map: Best Practices for U.S Bike Routes
God Bless America - RS - Issue V - 23Sep08
1. 2008
alternative investments in the world’s fastest growing markets
God Bless America
Roman Scott
Managing Director
Calamander Capital
Economic Spokesman
British Chamber of
Commerce Singapore
Issue V
23 September 2008
Calamander Capital
Economic Outlook, Q4 2008
2. 23 September 2008
God Bless America
I
often get accused of being anti-American. So I feel I should make it clear that I actually
like Americans. I really do. Of course, there are some obvious exceptions- George Bush
for example, Tom Cruise, David Letterman, Jim Cramer…you get the idea. But even they
are merely intensely annoying rather than inherently dislikeable. My antipathy for the US in
public commentaries has never been personal, purely economic. It is true that I once
likened the US dollar to toilet paper (long before it started its steady decline I hasten to
add), and have described the exceptional growth rates of the US economy as a grand fake.
But that’s because the former is, and latter was. The Fed has shown a proclivity to print
large quantities of dollars cheaply (Asian central banks demand keeping the yields low),
taking the dollar down to a shadow of its former self.
It now appears that the unfolding drama on Wall Street is finally catching up with the flaky
quality of recent US consumer led growth. Yes, Wall Street is collapsing. But no one’s going
to cry over a few deceased Lehman investment bankers who, if you checked, invested their
bonuses not in the toxic derivatives that they sold the world but in real stuff like Range
Rovers and Manhattan apartments. It’s the impact on the real economy that we need to be
Economic Outlook Q4, 2008 Page 2
3. 23 September 2008
worried about. For many years in my economic briefings I have been fond of using a
cartoon that depicts an average American Joe sitting in his living room, teetering
precariously on a pile of credit cards, as in walks the repo man to claim his dues. Forget
economists. Cartoonists get it right earlier, and more succinctly. Unfortunately for all of us,
as the house of cards that has been the US economy finally falls; it may well take us down
with it.
Nearly 10 trillion, or about 70%, of the 14 trillion dollar US economy is consumption. This is
healthy. But classical economics presumes that you should consume what you produce. Of
course, there are life-stage differences- young married with kids and school fees may
consume more, and use debt to cover the difference, whilst their ‘empty nester’ parents
have an excess of savings sitting in a bank, which funds such credit. The problem is that US
household debt levels, in aggregate, currently stand at over 135% of their income, a
problem that has been building for a long time. About 0.5% of the 3.5-4% US growth for a
decade has not been ‘real’ but debt financed. When that number is 14 trillion, that half a
percent, yearly, becomes a lot of debt. The debt was financed by America’s banks largely by
asset based lending, not cash-flow based lending (i.e. based on your income - remember the
days when you had to give banks a pay slip to get a mortgage?). Rather than have a job, all
one had to do was sit in an asset (hopefully yours) with your dog. And that asset was a
home. And the home was assumed to be forever rising in value. And therein lies the
problem - American consumers got used to using their homes as huge ATM machines, then
popping down to Wal-Mart and Home Depot in their SUV’s to load up on all sorts of nicely
priced stuff, which drove consumption along nicely. Those home values are now falling fast.
And, by the way, all that stuff was made in China, and the SUV was on finance also.
The bursting of the bubble I expected, along with many fellow economic pessimists. The
sudden, and almost arbitrary, collapse of the markets and the intermediary function of
banks is a nasty surprise. Instead of an orderly winding down of credit excesses and a return
to earth of asset values, we have a market crisis and, far worse, the paralysis of the banking
system. The ship was meant to slowly sink, allowing everyone to jump in the lifeboats, not
blow up. Given this turn of events, what can we expect from here on? Here is our latest call
on our old mantra: ‘it’s going to get worse before it gets better’.
The US economy
I keep saying that the US is in recession, and the US keeps on producing numbers showing
positive growth. So here’s my view, despite the official numbers. US consumers have run
out of cash. They are awash with credit, most of it tied to homes that have declined 15-25%
depending on location. They are over exposed on auto-loans and credit cards, which will
also start to go sour. They have no choice but to start to pay down the 135% of income
debt. They could turn to savings but they haven’t been saving anything for years (US
Economic Outlook Q4, 2008 Page 3
4. 23 September 2008
household savings/disposable income less than 2% since 2000, and almost zero since 2006).
After all, why save when you expect capital gains on your primary asset, your home, at over
10% a year. So, years of excess will lead to years of deleveraging. Consumers focusing their
efforts on paying down debt do not make good consumers. And those, who are sound and
want to buy a house, or invest in their good business, will find no bank willing to lend to
them. At the same time, the global energy inflation problem will continue to act as a tax on
consumption and add to the woes. Yes, slowing growth will reduce demand, as reflected in
recent commodity price falls, and reduce inflation. But that doesn’t mean oil gets cheap
again. It just gets less ridiculously expensive.
Housing, which has further to deflate, will affect corporate earnings, not just consumer
balance sheets. As much as a third of US GDP depends on the housing related eco-system:
construction, property sales and services, home décor, carpets, lighting, furniture, gardens.
As for the financial services sector, the US is now paying the price for dependence on a
sector that is much riskier and less stable than making things for a living. Financial services
were 5% of the US economy 25 years ago, it’s now nearly 20%, and too much of that is
trading orientated investment banking.
Finally, those living on savings-retirees and pensioners will be hit by lower interest rates
while inflation continues to erode their purchasing power. The Fed will likely resume
monetary easing-shifting policy back to boosting growth and easing the pain for banks,
rather than fighting inflation.
What goes for the US, applies to those that have followed their model. The UK looks
particularly weak, its banks and consumers similarly overextended. House prices in the UK,
Spain, and Central Europe are all inflated on income affordability measures. The rest of the
G3, less exposed directly to toxic derivatives, are too interconnected to be immune. Euro
land’s latest data doesn’t inspire, and Japan remains, as always, our favourite zombie
economy. Until the fundamentals of its appalling demographics change (it is virtually
impossible to grow with a shrinking population), I remain convinced that Japan will never
have any real pulling power again. And while I continue to firmly believe in the long term
secular transformation of Asia, that doesn’t insulate it from the US. I am not a believer in
decoupling - the data just doesn’t support it. Asia is more, not less, dependent on G3
exports. Much of the intra-Asian trade is semi-finished goods, such that over 60% of exports
remain G3 bound. All of the consumers in China and India combined merely cover about
20% of the consumption of the American shopper. Decoupling has a way to go yet. Yes
there are parts of Asia that are less export dependent with big consumer economies-India
and Indonesia in particular, and yes China’s strength will merely slow to a more sustainable
pace. A major benefit is that this will help solve Asia’s serious inflation problem. But
earnings have to start to slow, and analyst estimates will prove over optimistic, as they are
with the US. This will lead to a relatively poor next quarter and 2009 in the most open,
Economic Outlook Q4, 2008 Page 4
5. 23 September 2008
trade or tech orientated economies: Korea, Taiwan, Singapore, and Malaysia. The good
news is that it is Asia, which is the long run beneficiary of the new world order, and Asia will
continue to be where the growth is for the next decade and beyond. Asian markets will also
mend earlier than appears. There is further to go, no doubt, but the strength of the
downdraft will speed up the recovery. In the meantime, there will be fabulous
opportunities for the brave with cash, and Asia has the cash. If I had a few billion, I would
be joining the queue for AIG’s Asian life insurance operations.
The US Dollar
The US has already been paying the price for its decade long debt creation. The pressure
was let out in the dollar. Very quietly over the last five years, hundreds of billions of value
for global investors has been wiped out by dollar devaluation. But that’s the way to
meltdown - slowly. The Europeans were far too polite to complain too much, even though
the Euro took the brunt of relative strengthening (and loss of export competitiveness). And
the Chinese - well they were too busy making all the consumer goods for average Joe to
complain and upset the party, despite holding close to 2 trillion greenbacks (yes that’s
trillion with a ‘t’). However, by mid last year, the dollar appeared to have bottomed, and
this year has been gaining strongly against all major currencies. So many think the dollar is
back. Think again. The renewed vigour of the dollar is the result of a process, not a change
in fundamentals. That process is a global flight from risk and massive deleveraging, which
has been driving US and other investors to buy dollars and sell everything else. When that’s
done, it’s back to the (debt ridden) fundamentals. And guess what? The Fed has just added
another 5 trillion dollars to the existing 5 trillion pile of government debt by nationalising
Fannie Mae and Freddie Mac; and Mr. Paulson is about to add another trillion or two in
rescue money for the banks. I can hear the Treasury’s printing presses starting again. The
scary thought is that, after the dust has settled, Asian and Middle Eastern investors that
hold the largest stock of dollars and dollar debt are never going to look at the US again with
the same level of trust. Over time, that will lead to a continued slow exodus from the dollar,
and higher borrowing costs will have to follow. The Euro and Yen will grow in prominence,
as will the stronger Asian currencies. I promise I won’t use the toilet paper term again, but
we haven’t held a US dollar since 2003, and have no intention to change that position. We
are sticking to our long term favourite - the Singapore dollar, thank you.
The US Banking system
Media have been full of shell-shocked headlines: the horror, the extraordinary and utterly
unpredictable nature of these events. Even Alan Greenspan has said this is a once in a
generation event. This is all poppycock. These things happen, with alarming regularity. Mr.
Greenspan obviously wasn’t around Asia when our banking system melted down a decade
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6. 23 September 2008
ago. The Russian debt crisis and LTCM wasn’t a joyride. He’s old enough to recall the early
eighties savings and loan crisis. Even the tech/telecom bubble, when it burst in 2001, took
out well over a trillion dollars. The tech bubble from a credit view was a similar ‘The rules of
the markets have changed’ cult. Real cash flow (i.e. income) was abandoned as a basis for
credit over a modeled view of the capital value of the enterprise that was assumed to rise
forever (or to dot.com IPO). Sounds familiar. Switch the new, new thing to credit
derivatives, and the asset backing from dotcom enterprise to homes, and you have the next
Wall Street gravy train. It usually takes about five to six years before mere mortal investors
wise up, by which time the masters of the universe have made enough to see them through
the collapse until they can start the next cycle. Hopefully this time, yield hungry investors
have finally learnt that anything an investment banker sells is always a packaging of much
greater risk than you think, at higher ratings than it deserves, for far more than it should
cost. That goes for all derivative products.
There is one difference this time. Whereas last time round the young bucks in NY laughed
behind our backs at the nonsense they had created and sold to the world (remember Jack
Grubman, Henry Blodget et al. and their real views on the dotcom ‘garbage’), this time they
actually believed in their own fiction-the CDO. Their creators (a 24 year old nerd sitting in a
back room with two math’s degrees but no girlfriend) made the mistake all analysts make
and believed their own models. Their bosses, MDs at the best names in Wall Street, didn’t
want to admit that they didn’t they have a clue. The ratings agencies did what they were
told and labeled them AAA, because their own 24 year old nerds didn’t get it. If they were
that smart they would have been working for Lehman, not S&P. Over time, Wall Street
forgot that behind their CDOs remains a poor black family sitting in a dilapidated inner city
home with no ability, or intention, ever to pay it back. This time the fools in the market
were makers of the market.
As for the debate on moral hazards and Wall Street pay, well yes - duh. Of course if as a
bank, you allow an incentive system to develop that rewards highly leveraged risky bets
using the banks own capital, hold it on your own books, pay out 50% of any revenues made
from successful bets in massive bonuses to the employee in one go every year, but merely
fire her if it all goes wrong (and a week later your competitor hires her for even more), you
set yourself up to be taken advantage of. The foolishness was not the Wall Street
investment banks turning themselves into giant proprietary hedge funds, but that investors
bought into these businesses as if they were buying the stock of a real bank. Does bailing
them out create moral hazard? Of course. We did the same in Asia-with Korean banks,
Indonesian banks, and Thai banks. Does that mean it shouldn’t be done? Unfortunately not.
There is such a thing as ‘systemic risk’ to the economy - much like the major organs of the
body shutting down. When the vital intermediary function of ordinary banks taking deposits
from savers and lending to borrowers grinds to a halt, so does the economy. At its worst,
depositors can lose faith in their banks and cause a ‘run’, seeking to withdraw all their
Economic Outlook Q4, 2008 Page 6
7. 23 September 2008
savings at once, not realizing they are not actually ‘in’ the bank but lent out. Nothing spells
trouble more. This happened with the inaptly named Northern Rock in the UK (it wasn’t
very Northern, and it wasn’t much of a rock), all the way back in August last year, which
shows the state of denial that the markets have been in.
The only way to free up the system is to effectively nationalize it - Paulson has no choice.
Private follies have to be turned into public debt. Hank Greenberg argued that this was a
liquidity issue (for AIG), not insolvency. But when the market for credit disappears between
financial institutions, liquidity is solvency. Yes, this means ordinary taxpayers-honest, hard
working folk-paying for the sins of Wall Street fat cats, just as a decade ago farmers and
teachers in Indonesia had to pay for the sins of the Jakarta banking moguls. Unfortunatley,
the alternative is worse. Think of it as merely a couple of years of the Pentagon budget.
It remains only to say that we are not out of the woods yet. The state can rescue the banks
and get liquidity back into the sytem, but that doesn’t guarantee that they will use it the
right way-i.e. start the positive cycle of lending to creditworthy borrowers who invest in the
real economy. There are no powers that the Fed or the Treasury has that can force the
banks to lend again. Every credit crises leads to a state of paralysis for bankers, hence the
‘credit crunch’. They are shell shocked, they retreat into their caves and they shut the door.
The best businesses get the cold shoulder, and this severely crimps growth. This usually
lasts a couple of years at least. In Asia it took four. RTC or no RTC, this is a psychological
problem that only time can fix. That is the biggest risk to the world economy right now.
Is the end of an era?
Maybe not so fast. I still believe that the tipping point for US global economic and
geopolitical dominance peaked back at the turn of the century at the height of the last great
bubble in 2000. The rise of Asia began to take shape after several false starts, and the start
of a more unipolar world. But the US will continue to dominate for at least another decade
or two, just as the British, past their peak by 1875 in economic power, continued to rule the
waves for another forty years. But perhaps the days of supersized American consumption-
the gas guzzling V8 truck, the McMansions, the big slurp-will be tamed. In a decade,
average Joe in the US will look just like all of us, and drive a Honda Civic. And guess what.
So will a billion middle class Chinese and Indians. They want it too, and they will get it,
partly at the expense of the US. The greatest period of economic rebalancing in history is
upon us. And the world will be a better place. Or will it?
Economic Outlook Q4, 2008 Page 7
9. 23 September 2008
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Economic Outlook Q4, 2008 Page 9
