Tuesday, December 30, 2008

2009 Outlook

Pieter Breugel The Elder, The Blind Leading the Blind (1568),
Conservato alla Galleria Nazionale di Capodimonte, Naples

Humans seem innately clueless at predicting the course of their economies and financial markets, and most 2008 market predictions look pretty ludicrous now. Anyone looking to fellow mortals for clues to the financial course of 2009 should remember the parable: "Can the blind lead the blind? Shall they not both fall into the ditch?"

To avoid the ditch, consider the following list not as a New Year's prediction but as an attempt to identify important factors and trends for consideration when contemplating the course of US and world economies and markets in 2009:


The financial crisis is part of a long term process of change. Some of the adverse changes will correct, but slowly. Some of the changes are permanent.

The immediate crisis is one of too-easy credit and poor risk management. It took years to build up consumer and government debt, and it will take years to work through the crisis brought on by that debt. The process of credit recovery has not even started. Consumers are still in debt and losing their jobs. They are under water with their houses, prices are still declining, and houses are still not affordable. As for the availability of credit, price discovery for toxic assets is still a long way off, and the day of highly leveraged credit is over.

The change in consumer behavior is a generational event. Consumers can now see the folly of spending themselves into debt, and they are rueing the consequences. It is likely that their embracing of a more frugal lifestyle is permanent. When the pace of economic activity recovers in the US, it will be to a lower level than the nation has been accustomed to.

The credit crisis is only one part of a long-term process of change that is affecting the entire world and will continue to put pressure on the US economy. After World War II the US was the only large industrial nation in the world with its plant, equipment, and work force remaining intact. The advantage that this gave the US economically has eroded over time, first as Europe and Japan recovered, and then as the developing world took off.

The hollowing out of the US has gone on for decades. We have seen industry after industry leave these shores and set up where labor is cheaper and management is nimbler. I'm not talking about buggy whips and whale oil: Textiles, consumer electronics, auto manufacturing and many others are vibrant industries that generate money and are based on important technologies.

In the face of competition, US industry and wages did not keep up with the pace of change. Debt filled the lifestyle gap for many Americans until recently. Now that the credit bubble has burst, consumers can no longer maintain lifestyles by going into debt and going to the housing ATM. They can now see that they are poorer than they formerly thought. They can see that they do not have a birth right to luxury and a fine life style. Americans are part of the wider world, and competition for the good life is here to stay.

Industry after industry collapses in the US and prospers overseas. What are Americans to do when the last industry fails? Sell hamburgers to themselves? We can see how hollow the promise of a "service economy" was.

When the last industry fails, will we be able to invent an industry to take its place? Maybe we have been expending resources on the wrong things.

Yes, we are still rich compared to most people in the world. Yes, improvements in technology may continue to improve everyone's life, even if our relative position in the world declines. Meeting expectations is another matter. Maintaining a vibrant economy is another matter.


There are already warnings in the press that vulnerable retailers will start to fail. Mall vacancies are increasing, and it will be difficult to make consumers spend what money they have.

As tax revenues drop, states and municipalities are in severe budget trouble and will be forced to economize. They will be challenged to deal with public pension funds stresed by stock market losses. Layoffs of public employees threaten to add to economic woes, and essential services will be stressed.
The rolls of the unemployed are growing and people are running out of benefits. Many support networks are already stretched to the breaking point.

Baby boomers approaching retirement have seen their investments evaporate but have few prospects of being able to work longer to fill the gap.
Demand for goods and services is dropping, and even the official statistics may eventually reflect the deflationary reality.

The Obama administration will use fiscal policy to try to counter the drop in consumer spending and business investment. Already there are warnings that the initial stimulus package (as large as it is) will not be enough, and that Congress will have to pass another package later next year. We will see how far this policy gets, and how long its effects last.


I hate to say "it's different this time", but the world does change.

After the the Federal government's unprecedented intrusions into the financial markets this past year, financial markets are operating under more uncertainty than ever. When will failing enterprises be allowed to fail? How creditworthy is an apparently investment grade security? Who really owns an enterprise? Will the government honor its own guarantees to investors? These factors will drive valuations of securities for all the enterprises touched by Federal bailouts, but the government has changed its mind often enough to leave investors uncertain of the rules. As mentioned in a Dec 30 New York Times article, In 2009, Economy Will Depend on Unlocking Credit, investors will be hesitant to risk their money until they know the rules.

If investing has been politicized, one approach is to buy what the government supports. As Bill Gross implied in an interview (Big Brother Investing) in Forbes, some of the government's support rules have been established. If the government will continue to throw money at ailing financial institutions, it is presumably safe to invest in sufficiently senior debt of those institutions.

Finding wealth in the stock market is looking less likely. Consumer frugality, declining demand overseas, and the prospect of increased regulation suggest that corporate profitability is unlikely to return to levels seen in recent years. Government promises to consume a bigger share of economic resources. Less leverage and a lower investor risk appetite threaten to reduce the demand for equities.

Many observers suggest that investment-grade investment debt as the place to invest in the new year. Others worry that a surge in US debt issuance (to pay for bailouts and stimuli) will crowd out private debt. Whichever way it goes, a lot of money rides on the the government's issuance and the reaction of the bond market.

Some day in the future, Jim Rogers will be proven right, and we will see a definite and sustained renewal of the uptrend in overall commodity prices. It is hard to imagine this for 2009, but at some point prices will reach a level where those with a long-term planning horizon will start to accumulate commodities. Maybe some selected commodities are already at that point.


We have already seen the Federal government react wildly to the financial crisis with an ill-considered and ineffective bailout package for the financial industry. With this track record, there is more than enough reason to mistrust future government actions. A failure to restart the economy could lead to yet more wild measures.

Need a concrete example? A recent posting on The Big Picture (Low Mortgate Rates to Spur New Wave of Defaults) already suggested that a failure to restart housing could be met with a wild measure such as permitting "no appraisal" re-fi's. What a prescription for worsening the crisis -- extending loans to unqualified recipients who are already under water.


Beggar Thy Neighbor. In a depression, every country wants to protect domestic industry from foreign competition, and one way of doing that without formal trade barriers is to debase your currency. The hope is to avoid protectionist reactions by debasing currency enough to make products cheap to trading partners and their products expensive to import. In view of the skyrocketing Federal deficit, the US might be well on its way to debasing its currency. If other countries follow suit, will any currency be worth anything?

However, other countries are in economic trouble too. Far from sinking the dollar, our trading partners may fight hard to debase their own currencies and support the dollar. On the other hand, they may lose patience with our sinking currency and let us sink.

Protectionism. The President-elect has already mentioned the possibility of raising trade barriers to protect American jobs. This is a sure way to worsen the crisis, which we can hope will be avoided.

Foreign Support of US Indebtedness. Trade partners have found it in their interest to park funds in US Treasury securities and to pursue currency policies supportive of exporting to the US -- and to supporting US over-consumption. Now that US Federal debt threatens to skyrocket, there is the oft-mentioned risk that China and others may cut their losses and withdraw support from Treasury prices and the dollar. However, these trade partners have much to lose from such a disruptive move. Continued deleveraging of the financial system should also tend to support the dollar.


Social Change in Developing Nations. Reduced demand in the First World for manufactured goods and natural resources is being felt in much of the developing world in terms of sharply increased unemployment in the export sector of their economies. Depending on their circumstances, different nations will face different challenges in managing the consequences of the downturn. There have already been protests by the unemployed in Russia. Will China be able to find a role for the newly unemployed, for example, reintegrating returning workers back into rural economies? Oil-rich nations may also be stressed as they cut back on consumer subsidies and public projects. The outcome of all these social and political stresses is far from clear, but we should remain alert for disruptive changes that could exacerbate the economic downturn.

Social Change in the US. This crisis has brought about big changes in lifestyle and attitudes for many Americans. Considering the degree to which elite groups continue to profit from the crisis at the expense of the majority of America, it is surprising that social reactions have been very muted so far. What kinds of reactions could arise? Extremist movements among the dispossessed hopeless? Violent reactions to economic reversals have happened before in this country. Or perhaps positive changes will occur, such as an increase in community participation and other cooperative ventures. Something unexpected in the human dimension may very well come out of this crisis.

Smarter Economic Policy. The American people may soon realize that budget deficits, easy credit, and unregulated financial markets have resulted only in wasting their precious, limited resources. Resources squandered on leveraged speculation and on unnecessary consumption and housing were unavailable for savings and investment. Without savings, there was no investment. Without past investment, America today lacks the human capital, national infrastructure, and efficient industrial processes necessary to compete in today's world and provide for the Americans of tomorrow. Good times are some time off in the future, beyond 2009, because it takes time to save, invest, and build an economy.

Surprises of Nature. Everything we do depends on the natural world, and that is changing too. Global warming always poses the risk of disrupting human enterprises through unexpected extremes in the climate.


Evolutionary success depends on the ability to adapt to changing circumstances. We cannot predict the future, but we can watch events unfold and try to adapt. To do that, we need to know what kinds of events to watch for, and a framework in which to interpret events. The purpose of this list is to stimulate that process a little bit for 2009.

We are sure that readers have their own ideas, and we hope that they can improve on this framework and profit in 2009. Let me hear your thoughts.

Cassandra, Evelyn de Morgan (1855-1919),
De Morgan Centre, London